Examine Quantity Theory of Money

Structural Change by 1973 Oil Crisis

Part A  Examining the Quantity Theory of Money Part B  Test Whether 1973 Oil Crisis cause a structural change

About Quantity Theory of Money

 The Quantity Theory was first developed by Irving Fisher in the inter-war years as is a basic theoretical explanation for the link between money and the general price level .

 Roughly speaking, the Quantity Theory try to explain the cause of inflation.

 The Theory is argue that the i nflation is caused by the growth of Money Supply

Cause of inflation

1) The Quantity Theory 2)    Neo-Keynesian Cost push inflation Demand pull inflation Built-in inflation

Methodology

 Fisher identity or equation of exchange  M is the money supply MV = PY  V is the velocity of circulation of money  P is the general price level  Y is the real value of national output (i.e. real GDP)

 Fisher identity or equation of exchange

MV = PY lnM + lnV = lnP + lnY

 To test the cause of growth of price level (inflation), we yield

lnP = lnM + lnV - lnY

 To simplify our examining, we hold the growth rate of the velocity of circulation of money (V) being constant ( β 0 ) .

 Thus, we yield the regression like this:

lnP =

β 0

+

β 1

lnM +

β 2

lnY

Sample

 Country: United States  Period: 1959Q1 to 2010Q3  Data:  M is M2  P is the GDP Deflator  Y is the real GDP

Result

 We run a OLS estimation on the regression:

lnP =

β 0

+

β 1

lnM +

β 2

lnY

The result is: lnP = 2.918171 + 0.893281 lnM - 0.650627 lnY (0.33306 ) (0.028347 ) (0.061715 ) R-squared = 0.992265

RSS = 0.603807

 We can conclude that the Quantity Theory of Money significantly explain the cause of inflation

Test Whether 1973 Oil Crisis cause a structural change

 1973 Oil Crisis lead the GDP growth of US decreased by 4.7%  It shows that 1973 Oil Crisis is a serious economic shock for US  It is worth to test that whether 1973 Oil Crisis bring a structural change (in term of the effect of the growth of money supply and output to the inflation.)

Methodology

 The Chow test is used to do the test.

 Separate the whole period to two sub-periods:  1959Q1 to 1973Q3  1973Q4 to 2010Q3  Establish the Hypothesis: H 0 : H 1 No structural change, Var(  1 )=Var(  2 ) = σ 2 : Yes, there is a structural change, Var(  1 )≠Var(  2 )≠ σ 2

• Run OLS on two sub-sample groups separately and obtain the RSS 1 , and RSS 2 , ( RSS 1 + RSS 2 =RSS UR ) Run OLS on the whole sample (N) and obtain the restricted RSS R  Compute: 

F

*

=

[( RSS R RSS 1 RSS 2 )/k+1]/ (RSS 1 + RSS 2 )/N-2k-2 

If F

*

> F

c  , k+1, N-2k-2

==> reject H

0

  RSS R

(Whole Period)

= 0.603807

 RSS 1 (1959Q1 to 1973Q3) = 0.029737

RSS 2 (1973Q4 to 2010Q3)= 0.445407

   By computation: F*= 18.14275 , where F c =3.9491

Where α=0.01

 Since F*= 18.14275 , F c =3.9491

 F * > F c  , k+1, N-2k-2 ==> reject H 0  There is a structural change, Var(  1 )≠Var(  2 )≠ σ 2  We can conclude that the effects of the growth of money supply and output to the inflation have had a structural change after 1973 oil crisis!