A Statistical Analysis of Economic Interventionism

Kevin S. Hu, Ryan P. Furey, James P. Hogan, Felipe A.S. Da Cruz May 2, 2012

Abstract

The purpose of this project is to bring to light a series of noteworthy and thought-provoking correlations. Inherent in this statistical analysis is the understanding that, although the correlations may be signicant, one must be wary of the dangers of extrapolation associated with any analysis. With this said, this paper is intended to expand on the data associated with scal or monetary interventionism in the U.S. economy. This study has collected data from the U.S. Bureau of Labor Statistics and the Federal Reserve from 1960 to the present on rates of unemployment, consumer price index, ination, GDP, money supply, money velocity, price level, GDP per capita, and labor force participation. From these sets of data one can transform the variables necessary to run regression analyses, and it is this papers purpose to do so in what was found to be a meaningful manner. From these regression analyses, resulting correlations, or lack thereof, have been expanded, and the resulting arguments that could possibly be created from the evidence found have been noted.

A Statistical Analysis of Economic Interventionism

Introduction

Many issues that plague societies around the world are a result of economic issues. Poverty, hunger and malnutrition, and even some wars are fought due to economic factors. As such, the study of economics is crucial for the advancement of societies everywhere. Two poles have emerged in terms of government policy in economics - one characterized as laissez-faire and the other as economic planning. Laissez-faire strategy, in which the government plays no role in the economy, relies on the invisible hand that guides the economy toward the common good, as theorized by the father of capitalism, Adam Smith. However, this strategy does not always lead to the common good. What should the role of government be in the economy? There is wide agreement about the major goals of economic policy: high employment, stable prices, and rapid growth. There is less agreement that these goals are mutually compatible or, among those who regard them as incompatible, about the terms at which they can and should be substituted for one another. There is least agreement about the role that various instruments of policy can and should play in achieving the several goals. - Milton Friedman The question regarding the role of government in the economy is contentious - thus, how do economists determine the best course of action for the government? What science can be used? Economics is, by nature, an observational science. It is impractical to actually experiment on societies, so economists are forced to rely on observed information to build models with which they propose to predict economic behavior. Statistical analysis can help determine the strength of these models by measuring how closely the models t observed data. This paper seeks to compare several theories of economic interventionism, and then to relate income inequality (commonly associated or even attributed to free markets and capitalism) with overall and per-capita economic performance. To accomplish this, it analyzes data about the U.S. economy from 1960 to the present.

A Statistical Analysis of Economic Interventionism

Contents
1 Abstract 2 Introduction 3 Theories of Economic Interventionism 3.1 The Exchange Equation . . . . . . . . 3.1.1 Methods . . . . . . . . . . . . . 3.1.2 Results . . . . . . . . . . . . . . 3.2 Quantity Theory of Money . . . . . . . 3.2.1 Methods . . . . . . . . . . . . . 3.2.2 Results . . . . . . . . . . . . . . 3.3 Fiscal Theory of Price Level . . . . . . 3.3.1 Methods . . . . . . . . . . . . . 3.3.2 Results . . . . . . . . . . . . . . 1 2 4 4 4 4 5 5 5 5 5 6 6 6 6 7 7 7 7 7 7 8 8 8 8 9 9 10 11 11 12 12 13 13 14 15

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4 Ination Rate as a Control for Unemployment 4.1 Phillips Curve . . . . . . . . . . . . . . . . . . . 4.1.1 Methods . . . . . . . . . . . . . . . . . . 4.1.2 Results . . . . . . . . . . . . . . . . . . . 4.2 New Phillips Curve . . . . . . . . . . . . . . . . 4.2.1 Methods . . . . . . . . . . . . . . . . . . 4.2.2 Results . . . . . . . . . . . . . . . . . . . 5 Income Inequality 5.1 Labor Force Participation 5.1.1 Methods . . . . . . 5.1.2 Results . . . . . . . 5.2 Economic performance . . 5.2.1 Methods . . . . . . 5.2.2 Results . . . . . . . 6 Conclusions and Discussion 7 References A Appendices A.1 Exchange Equation . . . . . A.2 Quantity Theory of Money . A.3 Fiscal Theory of Price Level A.4 Phillips Curve . . . . . . . . A.5 New Phillips Curve . . . . . A.6 Labor Force Participation . A.7 Economic Performance . . .

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A Statistical Analysis of Economic Interventionism

3
3.1

Theories of Economic Interventionism

The Exchange Equation

An overarching tenet in economic policy is the exchange equation, which states: M V = P Q, where M represents the amount of money in circulation, V represents the transactions velocity of money, P represents the transactions price level, and Q represents economic output. 3.1.1 Methods

The Exchange Equation is identically true, but its validity can be tested regardless using quarterly data from January 1st, 1960 to July 1st, 2011 (see pvmq.csv, columns m, v, p, and q). The data is readily available from the Federal Reserve Bank. It is dicult to run a regression on the original Exchange Equation, but the equation can be manipulated so that it is more linear: M V = P Q log(M V ) = log(P Q) log M + log V = log P + log Q. Then a multiple regression on the data can determine whether a model of this form is signicant, with an R2 value close to 1 and an F -test p-value less than 0.01. 3.1.2 Results

Multiple linear regression produces the following equation: log Q = 0.9257567 log P + 1.022252 log M + 1.132964 log V + 3.971635 P 0.9257567 Q = 103.971635 M 1.022252 V 1.132964 . This form matches that of the Exchange Equation, with factors due to specic measures used: for M , the M2 money supply; for V , the M2 money velocity; for P , the U.S. Consumer Price Index (CPI); for Q, the U.S. real gross domestic product (real GDP). Moreover, this relation is extremely strong, with an R2 value of 0.998. An F -test returns a probability of virtually zero, suggesting that the model is strongly signicant. The p-values associated with t-tests on each of the individual variables also return probabilities of virtually zero. The residuals show a clear pattern, failing a kurtosis test. Similarly, the test fails the Breusch-Pagan and Cook-Weisberg test for heteroskedasticity. On both tests, the p-values returned by the tests are below 0.01, suggesting high statistical signicance. However, since the exchange equation is identically true, the variables are deeply related, and there was strong multilinearity in the data. Thus the heteroskedasticity and kurtosis levels of the model produced are not concerning.

A Statistical Analysis of Economic Interventionism

3.2

Quantity Theory of Money

The Quantity Theory of Money suggests that money supply and price level have a direct proportional relationship. It is an extension of the Exchange Equation that is associated with the Monetarist school of economics. 3.2.1 Methods

If money supply and price level have a direct proportional relationship, a linear regression on M and P should return a positively-sloped line with F -test p-value below 0.01 and an R2 value near 1. This analysis uses quarterly data from January 1st, 1960 to July 1st, 2011 from the Federal Reserve Bank. If the F -test returns a p-value less than 0.01 and the t-test for the signicance of the independent variable also returns a p-value less than 0.01, it is a strong suggestion that the model is accurate. For P this analysis uses the CPI and for M this analysis uses the M2 money supply (see pvmq.csv, columns m and p). 3.2.2 Results

A single regression on M and P produces the model: P = 0.0128719M + 18.44568. The F -test and t-test both return p-values of virtually zero. Also, the R2 value is 0.9362, suggesting an extremely strong correlation. While the model fails our tests for heteroskedasticity, multilinearity again plays an important role. The fact that a linear model with positive slope relates price level and money supply so strongly suggests that for the past fty years, in the U.S., the Quantity Theory of Money has in fact been valid.

3.3

Fiscal Theory of Price Level

The Fiscal Theory of Price Level suggests that government scal policy aects ination; namely, it suggests that government budgets must be balanced in order to stabilize ination. As a heterodox economic theory, it is not widely accepted, although the Fiscal Theory of Price Level and the Quantity Theory of Money are not mutually exclusive. 3.3.1 Methods

If the Fiscal Theory of Price Level holds, there should be some correlation (positive or negative) between government budget surplus/decit and ination. Therefore, this analy-

A Statistical Analysis of Economic Interventionism sis examines the relationship between these variables (see pvmqyear.csv, columns pi and deficit). 3.3.2 Results

According to the scattergram of ination and surplus/decit, there is no obvious relationship among the points. The regression model gives a p-value for the F -test of 0.4826, which is not signicantly signicant; the R2 value is 0.0101, which suggests there is no correlation between the variables. Then for the past fty years in the U.S., the Fiscal Theory of Price Level has not been valid.

Ination Rate as a Control for Unemployment

In order to control the unemployment rate, governments often result to tactics that can change the ination rate (e.g. increasing/decreasing the money supply). Although the theory is commonly disbelieved in modern economics, the theory of the Phillips Curve was an important principle in traditional Keynesian economics. The Phillips Curve was a proposed inverse correlation between ination and unemployment; historically, it sometimes held true during short periods of time, but was never showed to hold in the long term. Does it hold for the recent American economy?

4.1

Phillips Curve

The Phillips Curve suggests that ination and unemployment are inversely related. Its validity can be tested for the recent American economy through determination of the accuracy of a model of this form. 4.1.1 Methods

Let ination be represented by the variable and let the unemployment rate be represented by the variable rU . If the Phillips Curve is indeed accurate, for some constant c:
1 rU = c = crU . 1 Thus a regression of against rU will determine if the Phillips Curve matches the data have from the previous fty years in the U.S. (see pvmq.csv, columns pi and ue). The variable can be generated based on monthly relative changes in CPI.

A Statistical Analysis of Economic Interventionism 4.1.2 Results

The data does contain an outlier with < 0.02; once this outlier is removed, the model is still relatively inconsequential, with the t-test returning a p-value of 0.8896, which denitely is statistically insignicant. The R2 value is 0.0001, suggesting almost no correlation between ination and the unemployment rate. Thus, the Phillips Curve has not been accurate for the U.S. in the past fty years. This may largely be a result of the 1970s, an example of rampant stagation, with high unemployment and high ination caused largely by supply shocks such as the 1973 Oil Crisis.

4.2

New Phillips Curve

The New Phillips Curve is a theory suggesting that the change in ination is negatively correlated with unemployment; it was a derivative of the original Phillips Curve proposed after the original theory fell into disuse. 4.2.1 Methods

A regression of the change in ination against unemployment rates can determine whether or not a negative correlation exists, and if so, how powerful the correlation is (see pvmq.csv, columns dpi, and ue). If the t-test returns a p-value greater than 0.05, the model is signicantly insignicant, and the correlation is weak, if existent. 4.2.2 Results

The model that determined has a p-value for the t-test of 0.9847, suggesting the insignicance of the model and the weakness of the correlation. The R2 value is virtually zero, suggesting the correlation essentially does not exist. The New Phillips Curve has thus been inaccurate for the U.S. in the past fty years.

Income Inequality

Income inequality is commonly measured by the Gini coecient - a higher Gini coecient implies higher inequality.

5.1

Labor Force Participation

After the 2008 nancial crisis, analysts were concerned that although the economy has been recovering in terms of the unemployment rate, the labor force participation rate has de-

A Statistical Analysis of Economic Interventionism creased, suggesting that perhaps the unemployment rate has at least partially decreased as a result of the formerly unemployed leaving the labor force, discouraged from seeking jobs. An interesting problem is to determine the relation between income inequality and the labor force participation rate. 5.1.1 Methods

Regression of the Gini coecient and the labor force participation rate, if it results in a p-value for the F -test that is less than 0.01, produces a signicant model. Also, the Ramsey Regression Equation Speciation Error Test (Ramsey RESET) determines if the model is polynomial as opposed to simply linear. The data used in the analysis is annual data from the Federal Reserve Bank for the U.S. in the past fty years (see pvmqyear.csv, columns gini and participation). 5.1.2 Results

Although the linear regression returns a p-value for the F -test of virtually zero, the model can be improved as a quadratic model, as suggested by the Ramsey RESET, which returns a p-value of virtually zero. If we let G represent the Gini coecient and represent the labor force participation rate, the quadratic model that is generated is: G = 0.0014261
2

0.1682947 + 5.3205.

This is clearly not a model that can be extrapolated from, since 0 G 1; however, it accurately models the data from the previous fty years. The p-value is still virtually zero. The Ramsey RESET returns a statistically insignicant p-value of 0.0651. Since this model is monotonically increasing over our data domain, it suggests that the Gini coecient and labor force participation rate are positively correlated. This is particularly interesting as it suggests that when more people enter the labor force, income inequality actually increases, although this is a correlative and not a causative relation.

5.2

Economic performance

It is also interesting to determine the relation between income inequality and economic performance. Does income inequality preclude economic growth? Are they reconcilable? 5.2.1 Methods

Two measures of economic growth that can be analyzed are real GDP and real GDP per capita. Regression on each with the Gini coecient can determine whether or not a positive

A Statistical Analysis of Economic Interventionism or negative correlation exists. Again, the Ramsey RESET can be used to determine if the model is polynomial. The data used is from the same source as above (see pvmqyear.csv, columns gini, q, and gdppc). 5.2.2 Results

A linear regression of real GDP with Gini coecient returns a p-value of virtually zero, but the Ramsey RESET suggests (p = 0.0041) that the model should instead be quadratic, for which we nd the equation: Q = 569696G2 359637.9G + 60117.64 with a p-value of virtually zero and a Ramsey RESET p-value of 0.0879, which is statistically insignicant at an -level threshold of 0.05. This suggests that as income inequality increases, real GDP increases as well; this is a correlative and not a causative relationship. A linear regression of real GDP per capita with Gini coecient returns a p-value of virtually zero, and the Ramsey RESET suggests that the model is indeed linear. Then the model is: Qpc = 268937.2G 72955.25 with a Ramsey RESET p-value of 0.1328, which is statistically insignicant. This suggests that as income inequality increases, real GDP per capita increases as well; however, again, it must be emphasized that this is a correlative and not a causative relationship. Overall these results suggest that income inequality is quite strongly positively correlated with economic performance and average standards of living.

Conclusions and Discussion

Based on data from the past fty years in the United States, the Exchange Equation has held, as has its derivative, the Quantity Theory of Money. However, the Fiscal Theory of the Price Level, the Phillips Curve, and the New Phillips Curve all appear to be obsolete. Also, income inequality and economic growth, two concepts that are contentious in the ethics of economics, seem to be negatively correlated. To determine these results, we used multilinear regressions on the raw data itself, or if necessary, on manipulations of the data that were mathematically necessary. In general, the results were quite stark - either the models were extremely accurate (with a p-value less than 0.01) or were extremely inaccurate (with a p-value greater than 0.05), so the results would still hold given any sensible -level of signicance.

A Statistical Analysis of Economic Interventionism A division of CPI by a factor of 100.9257567 , multiplication of M2 money supply by a factor of 101.022252 , or multiplication of M2 money velocity by a factor of 101.132964 would result in a multiplication of real GDP by a factor of 10. For each additional dollar in the M2 money supply, CPI increases by 0.0128719, indexed to 2005. For each additional increase of 0.01 in the Gini coecient, GDP per capita increases by 2689.37 USD. Similar simplistic slope statements cannot be stated for the relation between GDP and the Gini coecient or between the Gini coecient and the labor force participation rate, as both models are quadratic. Both models are, however, positive correlations. While statistical analysis of several economic quantities yields, as described above, several interesting results, it is important to note that regression analysis determines the strength of correlations, not of causations. This is a particularly dangerous dierence in economic data; for example, since real GDP has increased over time in general, any other variable that increases over time will be somewhat correlated with real GDP, although the growth rates must be similar in order for linear models or quadratic models to match. Thus it is not correct to conclude that income inequality causes economic growth; nor is it correct to conclude that economic growth causes income inequality. The analysis only demonstrates that income inequality and economic performance tend to grow together and fall together - the economic variables are intricately and complexly related to each other through means that even multipolynomial regression cannot describe with great condence. This study adds fuel to the re for the controversy regarding the role of government in the economy. It shows that government action can aect price levels and economic output, and that income inequality, commonly associated with the free market, can lead to higher economic growth. Future studies that could test the veracity of these conclusions as well as broaden their implications to the rest of the world include similar studies in other countries (e.g. China, Japan, and the Euro zone), as well as studies with more historic data.

References
StataCorp (2010). StataSE (Version 11) [Computer software]. College Station, TX: StataCorp LP Economic Research - St. Louis Fed. Economic Research. Web. 02 May 2012. {<http://research.stlouisfed.org/> U.S. Bureau of Labor Statistics. U.S. Bureau of Labor Statistics. U.S. Bureau of Labor Statistics. Web. 02 May 2012. <http://www.bls.gov/>

A Statistical Analysis of Economic Interventionism

A
A.1

Appendices
Exchange Equation

A Statistical Analysis of Economic Interventionism

A.2

Quantity Theory of Money

A.3

Fiscal Theory of Price Level

A Statistical Analysis of Economic Interventionism

A.4

Phillips Curve

A.5

New Phillips Curve

A Statistical Analysis of Economic Interventionism

A.6

Labor Force Participation

A Statistical Analysis of Economic Interventionism

A.7

Economic Performance

A Statistical Analysis of Economic Interventionism