ECO 404 RHODES UNIVERSITY EXAMINATION: JUNE 2009 ECONOMICS HONOURS ECONOMETRICS (ECO404) Prof C Van Walbeek Ms N S Cattaneo

Answer all questions

Examiners:

MARKS: 110 DURATION: 3 hours

Question 1 (21 marks) The following model investigates wage inflation as a function of expected price inflation: WAGEINFt = 1 + 2PRICEINF*t + ut (Equation 1.1)

where WAGEINF is the % change in the money wage level, and PRICEINF* is the expected % change in the general price level (i.e. the expected inflation rate) 1.1 Show how Equation 1.1 can be transformed into Equation 1.2 below for estimation purposes:
WAGEINFt = 1 + 2PRICEINFt + (1-)WAGEINFt-1 + vt where vt = ut (1-)ut-1 (Equation 1.2)

Ensure that you clearly state and explain the underlying hypothesis and show the algebraic manipulations.

(4)

An OLS estimation of Equation 1.2 using annual data from 1960 to 1995 yielded the following results.
Dependent Variable: WAGEINF Method: Least Squares Date: 05/21/09 Time: 09:40 Sample (adjusted): 1961 1995 Included observations: 35 after adjustments Coefficient C PRICEINF WAGEINF(-1) R-squared Adjusted R-squared S.E. of regression Sum squared resid Log likelihood F-statistic 4.212221 0.320803 0.482993 0.679702 0.659683 3.616655 418.5663 -93.08887 33.95349 Std. Error 1.578942 0.135756 0.149926 Mean dependent var S.D. dependent var Akaike info criterion Schwarz criterion Hannan-Quinn criter. Durbin-Watson stat t-Statistic 2.667749 2.363081 3.221537 Prob. 0.0119 0.0244 0.0029 15.41429 6.199627 5.490793 5.624108 5.536813 1.462719

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Prob(F-statistic) 0.000000

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1.2 1.3 1.4 1.5 1.6 1.7

ECO 404 Write down the estimated regression equation. Comment on the individual and overall statistical significance of the results. (3) Compute and interpret the estimated coefficient of expectation. (2)

Carefully interpret the coefficient of the PRICEINF variable in the estimated equation. Explain whether its sign accords with a priori expectations. (3) Use the regression results for Equation 1.2 to obtain an estimated function for Equation 1.1. Explain your workings and write down the estimated function for Equation 1.1. (3) Carefully interpret the coefficient of the price inflation variable obtained for Equation 1.1, comparing it to the corresponding coefficient interpreted in Part 1.4. (2) What are the two major problems associated with the use of the OLS method in the adaptive expectations context, and what are their consequences? (4) (26 marks)

Question 2

Consider the following linear and non-linear demand functions for meat for a SACU member country: Linear: Non-linear: Qmeatt = 0 + 1 Pmeatt + 2 Pfisht + 3 pdit + ut Qmeatt = 0 Pmeatt1 Pfisht2 pdi3 eut (Equation 2.1) (Equation 2.2)

Graphs of the series based on annual data from 1970 to 2005 are shown below. Consumption spending on meat (Qmeat) and personal disposable income (pdi) are measured in constant Rmillions. Pmeat and Pfish are price indices with a base year of 1980. 2.1 Comment on any noticeable trends in the graphs, and their possible implications for a time series study. (2)

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QMEAT
40,000 35,000 30,000 25,000 20 20,000 15,000 10,000 5,000 70 75 80 85 90 95 00 05 0 70 75 80 85 90 95 00 05 10 30 40

PMEAT

PFISH
80 600,000 500,000 400,000 40 300,000 20 200,000 100,000 70 75 80 85 90 95 00 05 70 75 80 85

PDI

60

90

95

00

05

2.2

Perform a double-log transformation on Equation 2.2. Label the resulting function Equation 2.3. What is the advantage of the double-log model in terms of the interpretation of the partial slope parameters? (Ensure that you frame your answer given the context of the variables in the model). (4)

The table below indicates the results of ADF unit root tests on the variables of the models for Equations 2.1 and 2.3. 2.3 On the basis of the results, classify each variable according to its order of integration (I(0), I(1), I(2) etc). Explain your method with reference to just one of the variables. With reference to the graphs in Part 2.1, justify the unit root test formulation that has been used in the table. (4)

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ADF UNIT ROOT TEST RESULTS (t-statistics)
Linear Model(2.1) Levels Qmeat -1.78752 0.6893 Pmeat -1.19077 0.8923 Pfish -1.57832 0.7738 pdi -1.21284 0.8922 1st diffs -5.0945 0.0012 -4.5755 0.0059 -8.8513 0.00 -5.4887 0.0004 ln pdi ln Pfish ln Pmeat ln Qmeat Log Model (2.3) Levels -2.35513 0.3952 -2.12307 0.5151 -2.23131 0.4581 -0.89243 0.9457 1st diffs -5.52979 0.0004 -6.2758 0.0001 -5.89383 0.0002 -6.36899 0.00

Intercept and trend included p-values in italics

OLS estimation results for the linear and double-log demand functions are given below.
Linear Model (2.1)
Dependent Variable: QMEAT Method: Least Squares Date: 05/22/09 Time: 09:01 Sample: 1970 2005 Included observations: 36 Coefficient C PMEAT PFISH PDI R-squared Adjusted R-squared S.E. of regression Sum squared resid Log likelihood F-statistic Prob(F-statistic) 627.5891 -1242.314 594.4349 0.065530 0.982674 0.981049 1134.997 41223014 -302.1996 604.9666 0.000000 Std. Error 664.7967 299.1215 140.8569 0.002665 Mean dependent var S.D. dependent var Akaike info criterion Schwarz criterion Hannan-Quinn criter. Durbin-Watson stat t-Statistic 0.944032 -4.153210 4.220133 24.59178 Prob. 0.3522 0.0002 0.0002 0.0000 21956.19 8244.846 17.01109 17.18703 17.07250 1.421164

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Log model (2.3)
Dependent Variable: LOG(QMEAT) Method: Least Squares Date: 05/22/09 Time: 09:04 Sample: 1970 2005 Included observations: 36 Coefficient C LOG(PMEAT) LOG(PFISH) LOG(PDI) R-squared Adjusted R-squared S.E. of regression Sum squared resid Log likelihood F-statistic Prob(F-statistic) -3.191072 -0.094616 0.057793 1.037166 0.984797 0.983372 0.058991 0.111357 52.93181 690.9664 0.000000 Std. Error 0.562864 0.138041 0.112345 0.045811 Mean dependent var S.D. dependent var Akaike info criterion Schwarz criterion Hannan-Quinn criter. Durbin-Watson stat t-Statistic -5.669348 -0.685418 0.514422 22.64033 Prob. 0.0000 0.4980 0.6105 0.0000 9.908461 0.457473 -2.718434 -2.542487 -2.657024 1.074042

2.4 2.5

Comment on the individual significance of the estimated slope parameters in the two sets of results. (2) Explain what is meant by cointegration and why it is important in this context. Explain the rationale behind the Engle-Granger test for cointegration. (5)

The results of unit root tests on the residuals of the linear and double-log model regressions are given below. 2.6 Complete the Engle Granger cointegration test for each model. (The Engle Granger critical values are -5.02 at the 1% level, -4.32 at the 5% level and -3.98 at the 10% level). (3)

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ECO 404
Linear model
Null Hypothesis: RESID01 has a unit root Exogenous: None Lag Length: 0 (Automatic based on SIC, MAXLAG=9) t-Statistic Augmented Dickey-Fuller test statistic -4.391789

Log model
Null Hypothesis: RESID02 has a unit root Exogenous: None Lag Length: 0 (Automatic based on SIC, MAXLAG=9) t-Statistic Augmented Dickey-Fuller test statistic -3.385847

2.7 2.8

Discuss which model you would choose. Justify your answer both theoretically and empirically. (3) Explain how you would investigate the short run relationship between the variables of the chosen model, and why this is important. Write down the equation you would use in this regard. (3) (17 marks)

Question 3 3.1

An investigation of the data generating process underlying the import price index (IMPP) from 1995Q1 to 2004Q4 is undertaken using the Box-Jenkins methodology. The results of a unit root test on the series in level terms and at first differences, as well as a correlogram of the series at first differences are provided. Use the information below to suggest an appropriate ARIMA model for the series. Ensure that your choice is justified with reference to the unit root test results as well as the PACF and ACF patterns on the first difference correlogram. (3)
ADF Unit root tests on IMPP in level terms and at first difference (t-statistics) Levels IMPP -1.24333
0.8870 p-values in italics

1st diffs -4.6331

0.0034

Intercept and trend included

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ECO 404
Correlogram of D(IMPP) Autocorrelation Partial Correlation . |** . |*. . |*. .*| . **| . .|. .*| . .|. . |*. .*| . | | | | | | | | | | . |*****| . |**** | . |*. | **| . | .*| . | . |*. | .|. | .|. | .|. | .*| . |

3.2

Correlograms of the residuals of two regressions that have been run for two possible alternative ARIMA models for IMPP appear below. On the basis of the residual correlograms, which underlying ARIMA model for IMPP would you consider to be more adequate: Model 1 or Model 2? Explain your answer with reference to both the correlogram patterns of the residuals and the significance of the Q-statistics. (3)
MODEL 1 Correlogram of RESID01 Date: 05/23/09 Time: 16:46 Sample: 1995Q1 2004Q4 Included observations: 37 Autocorrelation .|. .|. . |*. .*| . **| . .|. .|. .|. . |*. .|. | | | | | | | | | | Partial Correlation .|. .|. . |*. .*| . **| . .|. .|. .|. . |*. .*| . | | | | | | | | | | 1 2 3 4 5 6 7 8 9 10 AC -0.010 -0.016 0.178 -0.151 -0.219 0.037 -0.060 -0.042 0.143 -0.063 PAC -0.010 -0.016 0.178 -0.154 -0.225 0.002 -0.006 0.013 0.079 -0.103 Q-Stat 0.0042 0.0150 1.3660 2.3696 4.5419 4.6062 4.7799 4.8685 5.9264 6.1418 Prob 0.949 0.993 0.714 0.668 0.474 0.595 0.687 0.772 0.747 0.803

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MODEL 2 Correlogram of RESID02 Date: 05/23/09 Time: 16:54 Sample: 1995Q1 2004Q4 Included observations: 39 Autocorrelation . |*** . |** . |** .|. **| . .|. .*| . .*| . .|. .*| . | | | | | | | | | | Partial Correlation . |*** . |*. . |*. .|. **| . .|. .|. .|. . |*. .*| . | | | | | | | | | | 1 2 3 4 5 6 7 8 9 10 AC 0.242 0.130 0.186 0.035 -0.163 -0.028 -0.083 -0.088 0.054 -0.112 PAC 0.242 0.076 0.148 -0.050 -0.205 0.025 -0.055 0.006 0.103 -0.172 Q-Stat 2.4543 3.1836 4.7196 4.7763 6.0217 6.0600 6.4073 6.8075 6.9608 7.6471 Prob 0.117 0.204 0.194 0.311 0.304 0.416 0.493 0.558 0.641 0.663

3.3

Explain how a VAR model differs from a traditional simultaneous equation model. What are a VAR models main advantages and disadvantages? (5)

It is likely that the wage inflation and price inflation variables introduced in Question 1 are mutually determined. To explore this further, a VAR model consisting of the following two equations is set up.
WAGEINFt = 0 + 1 WAGEINF t-1 + 2 WAGEINFt-2 + 1PRICEINFt-1 + 2PRICEINFt-2 + u1t PRICEINFt = 0 + 1 WAGEINFt-1 + 2 WAGEINFt-2 + 1 PRICEINFt-1 + 2 PRICEINFt-2 + u2t

As before, WAGEINF is the % change in the money wage level; PRICEINF is the expected inflation rate. The results of the VAR estimation are given below.

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Vector Autoregression Estimates Date: 05/23/09 Time: 17:52 Sample (adjusted): 1962 1995 Included observations: 34 after adjustments Standard errors in ( ) & t-statistics in [ ] WAGEINF WAGEINF(-1) 0.951792 (0.18729) [ 5.08184] WAGEINF(-2) -0.466710 (0.19625) [-2.37812] PRICEINF(-1) -0.109053 (0.20057) [-0.54371] PRICEINF(-2) 0.348693 (0.18205) [ 1.91535] C 5.291620 (1.79756) [ 2.94379] R-squared Adj. R-squared Sum sq. resids S.E. equation F-statistic Log likelihood Akaike AIC Schwarz SC Mean dependent S.D. dependent 0.667405 0.621529 394.5959 3.688733 14.54826 -89.91944 5.583496 5.807961 15.73235 5.995995 PRICEINF 0.367167 (0.19365) [ 1.89601] -0.121506 (0.20292) [-0.59880] 0.564155 (0.20738) [ 2.72036] 0.105631 (0.18823) [ 0.56117] 0.442947 (1.85859) [ 0.23832] 0.740523 0.704734 421.8492 3.813990 20.69086 -91.05479 5.650282 5.874747 12.39706 7.018956 157.8569 114.8423 -177.1283 11.00755 11.45648

Determinant resid covariance (dof adj.) Determinant resid covariance Log likelihood Akaike information criterion Schwarz criterion

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3.4

ECO 404 Write down the estimated regression for the wageinf equation to two decimal places. Comment on the individual and overall significance of the results for both equations. (tcrit = 2.704 and 2.021 at the 1% and 5% levels respectively). (4) Part of the regression output for the same VAR model run at 4 lags is given below. With reference to three criteria in these results and those in Part 3.4, explain whether you would choose the VAR model with k=2 or k=4 on the basis of the information provided. (2)
Extract from the results of the VAR model with 4 lags (k=4)
Vector Autoregression Estimates Sample (adjusted): 1964 1995 Included observations: 32 after adjustments WAGEINF R-squared Adj. R-squared Sum sq. resids S.E. equation F-statistic Log likelihood Akaike AIC Schwarz SC Mean dependent S.D. dependent 0.661632 0.543939 348.2780 3.891339 5.621677 -83.60227 5.787642 6.199880 16.26875 5.762193 PRICEINF 0.734967 0.642781 379.7933 4.063588 7.972694 -84.98829 5.874268 6.286506 12.98438 6.798961 204.1289 105.4533 -165.3444 11.45902 12.28350

3.5

Determinant resid covariance (dof adj.) Determinant resid covariance Log likelihood Akaike information criterion Schwarz criterion

Question 4 (17 marks) As an economic journalist you have been asked to investigate the likelihood of retrenchments in certain sectors of the economy given the current economic climate. Given your brief, you assemble a dataset on 300 labour force participants in the manufacturing and education sectors of the economy. The following variables are included.
RETRENCHi SECTORi SKILLi AGEi GENDERi is a binary dependent variable set equal to 1 if the labour force participant has been retrenched and 0 otherwise. is a dummy variable set equal to 1 if the individual worked / works in the manufacturing sector and 0 if the individual worked / works in the education sector. is a dummy variable set equal to 1 if the individual is a skilled worker and 0 if the individual is semiskilled. is the individuals age in years is a dummy variable set equal to 1 if the individual is female and 0 otherwise.

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ECO 404 The results of an OLS estimation of the linear probability model RETRENCHi = 1 + 2SECTORi + 3SKILLi + 4AGEi + 5GENDERi + ui are given below.
Linear probability model
Dependent Variable: RETRENCH Method: Least Squares Date: 05/23/09 Time: 18:04 Sample: 1 300 Included observations: 300 Coefficient C SECTOR SKILL AGE GENDER R-squared Adjusted R-squared S.E. of regression Sum squared resid Log likelihood F-statistic Prob(F-statistic) 0.221046 0.221131 -0.303971 0.005656 0.414064 0.231866 0.221450 0.441915 57.61009 -178.1688 22.26183 0.000000 Std. Error 0.126179 0.063459 0.054640 0.002501 0.067525 Mean dependent var S.D. dependent var Akaike info criterion Schwarz criterion Hannan-Quinn criter. Durbin-Watson stat t-Statistic 1.751840 3.484629 -5.563134 2.261467 6.132001 Prob. 0.0808 0.0006 0.0000 0.0245 0.0000 0.500000 0.500835 1.221126 1.282855 1.245830 0.333327

The results of a maximum likelihood estimation of the logit model Li = ln(Pi/(1-Pi)) = 1 + 2SECTORi + 3SKILLi + 4AGEi + 5GENDERi + ui are given below.

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Maximum likelihood logit model
Dependent Variable: RETRENCH Method: ML - Binary Logit (Quadratic hill climbing) Date: 05/23/09 Time: 18:05 Sample: 1 300 Included observations: 300 Convergence achieved after 4 iterations Covariance matrix computed using second derivatives Coefficient C SECTOR SKILL AGE GENDER McFadden R-squared S.D. dependent var Akaike info criterion Schwarz criterion Hannan-Quinn criter. LR statistic Prob(LR statistic) Obs with Dep=0 Obs with Dep=1 -1.411414 1.042675 -1.461334 0.028563 2.015908 0.182999 0.500835 1.165937 1.227667 1.190642 76.10710 0.000000 150 150 Total obs 300 Std. Error 0.643406 0.323298 0.283558 0.012863 0.363578 Mean dependent var S.E. of regression Sum squared resid Log likelihood Restr. log likelihood Avg. log likelihood z-Statistic -2.193659 3.225124 -5.153556 2.220601 5.544636 Prob. 0.0283 0.0013 0.0000 0.0264 0.0000 0.500000 0.441947 57.61866 -169.8906 -207.9442 -0.566302

4.1 4.2 4.3 4.4 4.5

Why is the maximum likelihood method used for the logit estimation?

(3)

Discuss which model (logit or LPM) you would prefer both theoretically and with reference to the empirical results. (5) Using the logit results, interpret the estimated coefficient of the SECTOR dummy variable, giving the odds interpretation. (2) Using the logit results, estimate the probability that a 50-year old semi-skilled female worker in the manufacturing sector would be retrenched. (4) Use the logit results to compute the rate of change of probability of being retrenched with respect to age, for an individual with the characteristics described in Part 4.6. Carefully interpret your result. (3)

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Question 5

ECO 404 (12 marks)

In an investigation of the preferences of the inhabitants of Moria for goblets made from mithril or gold, Balin assembled the following grouped dataset.
Wealth 50 100 150 200 n 135 225 300 325 N 500 500 500 500 0.25 0.39 0.386 7 74.7685 0.24 0.2275 P 0.27 I f(I) 0.331 2 N f(I)2 54.8467 P(1-P) 0.1971 w wstar Istar wealthstar

WEALTHi is measured in thousands of silver coins; Ni is the number of inhabitants surveyed at that wealth level who buy either mithril or gold goblets only; ni is the number of inhabitants buying mithril goblets at that level of wealth. [The binary variable MITHi is equal to 1 if a mithril goblet is purchased and 0 otherwise (i.e. if a gold goblet is purchased)]. 5.1 Ignoring the problem of heteroscedasticity, and with the aid of the table above, complete and write down the two columns of data to be used in fitting the probit model Ii = 1 + 2WEALTHi + ui. Explain your workings. (3) Given that var(Ui) = (Pi (1-Pi)) / Ni f(Ii)2 in the probit model, explain how you would (theoretically) transform the equation in Part 5.1 to correct the problem. (3)

5.2 5.3

Complete the table and calculate the three columns of data to be used in estimating the transformed probit model. (6)

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ECO 404 Question 6 (17 marks)

The IBSA (India-Brazil-South Africa) Dialogue Forum wishes to investigate whether there are significant differences in the determinants of FDI across the three countries. A panel data-set is constructed with quarterly data on FDI for the three countries as a function of GDP growth (GDPGR), exchange rate volatility (ERV) and domestic inflation (INF) from 1995Q1 to 2007Q4. The general model is FDIit = 1 + 2 GDPGRit + 3 ERVit + 4 INFit + uit 6.1 Set up a panel data model which allows just for the intercepts of the FDI functions to differ across countries (but not over time), using the fixed effects (least squares dummy variable) approach with South Africa as the base (comparator) country. (3) Write down the FDI equation intercepts for each country. (2)

6.2 6.3 6.4

How would you test for cross-sectional differences in the intercepts of the FDI functions? What would such differences mean in this context? (3) Explain how you would extend the model of Part 6.1 using interactive dummy variables to allow for cross-country differences in the slope coefficient of GDPGR (i.e. 2). Carefully write down the new portion of the equation only (i.e. how you will expand the term 2 GDPGRit). (2) Use the new portion of the equation to write down the slope coefficients of GDPGR for each country. (2) Explain what cross-country differences in the slope coefficients of GDPGR would signify in the context of the model, and how you would test whether such differences were statistically significant. (3) Would a random effects model be suitable for this investigation? Justify your answer. (2) END OF THE EXAMINATION

6.5 6.6

6.7

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