In this assignment, you will compare the Quantity Theory of Money (Classical) to the Liquidity Preference Theory (Keyne- sian). As with the last assignment, you should obtain all data from the FRED website:
https://research.stlouisfed.org/fred2/ Instructions on how to run a regression using Excel can be found here:
https://www.excel-easy.com/examples/regression.html
You will be studying quarterly data from 2003-2015. You will be using the following data series for this assignment. You can search for the data series in Fred by using the identifier in parentheses.
• GDP - Real Gross Domestic Product, Billions of Chained 2009 Dollars, Not Seasonally Adjusted (GDPC1)
• Interest Rate - 10-Year Treasury Constant Maturity Rate, Percent, Not Seasonally Adjusted (DGS10)
• TIPS - 10-Year Treasury Inflation-Indexed Security, Constant Maturity, Percent, Not Seasonally Adjusted(DFII10)
• M2 - M2 Money Stock, Billions of Dollars, Not Seasonally Adjusted (M2NS)
• CPI - Consumer Price Index for All Urban Consumers: All Items, Not Seasonally Adjusted (CPIAUCNS)
1. The Quantity Theory of Money
(a) Write down the Quantity Equation. Describe how the Quantity Equation relates to the Quantity Theory of Money. How does money and GDP growth impact inflation?
(b) Graph the inflation rate (from CPI) and the difference between the rate of money growth and real GDP growth on a single chart. Do the two series move together, as the Quantity Theory predicts? What does the difference between the two series represent?
Instructions: To do this, find the CPI series on FRED. Then, go to "ADD DATA SERIES". First, add M2 as a new series; Second, add GDP to "modify" the second data series. Make sure that all data has frequency: quarterly and is in units: percent change from one year ago. Then, go to "EDIT DATA SERIES" and click "Create your own data transformation". Subtract GDP growth from Money growth. Focus on 2003-2015 and save the picture.
(c) Run a regression with the inflation rate as the dependent variable and the money growth rate and GDP growth rate as independent variables. Report the Coefficient & P-value for each variable. Also report the R-square. Interpret the coefficients.
2. Liquidity Preference
(a) Write down the Money Demand function. Explain how and why the interest rate affects the demand for real money.
(b) Graph the expected future inflation rate. The expected inflation rate is the difference between the interest rate from the treasury bond minus the TIPS.
(c) Run a regression with the inflation rate as the dependent variable and the real interest rate (interest rate - inflation rate), the expected inflation rate, and GDP growth rate as independent variables. Report the Coefficient & P-value for each variable. Also report the R-square. Interpret the coefficients.
(d) Which model/theory does a better job of explaining inflation? Why do you think that is?