FACTORS THAT AFFECTS THE CHANGES OF INFLATION IN THE US DURING THE PERIOD OF 1966 – 2012

More specifically, a quantitative estimate of the rate at which the decline in purchasing power occurs can be reflected in the increase of an average price level of a basket of selected

FOREIGN TRADE UNIVERSITY FACULITY OF INTERNATIONAL ECONOMICS

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MID-TERM ECONOMETRICS REPORT

TOPIC

FACTORS THAT AFFECTS THE CHANGES OF INFLATION

Table of Contents

1 THEOREOTICAL BASIS OF THE RESEARCH TOPIC 3

1.1 The relationship between inflation, wages and unemployment 3

1.1.1 In short-term 3

1.1.2 Long term 4

1.1.3 Conclusion 5

1.2 The relationship between inflation and CPI 6

2 MODEL SPECIFICATION TESTING THE INFLUENCE OF UNEMPLOYMENT, CPI, AVERAGE WEEKY EARNINGS ON INFLATION OF UNITED STATE DURING 1966-2012 7

2.1 Methodology in the study 7

2.1.1 Method to derive the model 7

2.1.2 Method to collect and analyze the data 7

2.2 Population Regression Model 8

2.3 Explanation of variables 8

2.4 Description of the data 10

2.4.1 Data sources 10

2.4.2 Statistical description of the variables 10

2.4.3 Correlation matrix between variables 11

3 ESTIMATED MODEL AND STATISTICAL INFERENCE 13

3.1 Estimated model and estimated result 13

3.2 Testing the level of relevance of the model 14

3.3 Testing the hypothetical violations 15

3.3.1 Testing Omit variable Ramsey Reset 15

3.3.2 Testing Multicollinearity 15

3.3.3 Heteroscedasticity 17

3.3.4 Testing autocorrelation 17

3.3.5 Testing normality of residual 19

3.4 Testing an individual regression coefficient 20

3.4.1 Testing the CPI 20

3.4.2 Testing the UNEMP 20

3.4.3 Testing the WGGR 20

3.5 Final result and Discussion 22

3.5.1 Final regression model 22

3.5.2 Discussion 22

4 CONCLUSION AND POLICY IMPLICATION 24

5 REFERENCES 25

ABSTRACT

In recent years, on social media, there has been a country that are “famous for” the word

Inflation – Venezuela From one of the wealthiest country on earth, with inflation,

Venezuela is immersed in poverty, violence and illness

So is inflation really a problem for the economy?

According to economists and the prestigious website Investopedia.com, Inflation is the

decline of purchasing power of a given currency over time More specifically, a quantitative estimate of the rate at which the decline in purchasing power occurs can be reflected in the increase of an average price level of a basket of selected goods and services in an economy over some period of time We need to clearly understand that the increase of the average price level here is the general increase of goods and services, not just a particular kind of good When the value of goods increases, it means that the purchasing power of money decline So that with the same amount of money, customers now can buy less than before Moreover, in case of relationship with other economies, inflation can be defined as the devaluation of a currency compared to others

However, the devaluation of the money doesn’t always mean that inflation has negative impacts on the economy Otherwise, the negative influences of inflation only occur when the governments are unable to control the increase intensity of it In this case, when inflation is not measured and adjusted, it can lead to many negative impacts on the national economy and even affect other economies For example: trade balance instability, push costs, shoe-leather costs or hoarding wealth Conversely, if inflation is only moderate, it will cause the labor market to reach equilibrium faster, ensuring discount rates and rediscounts in the money and money markets main At the same time, moderate inflation also helps goods and services markets avoid the jagged pattern

of price fluctuations

In fact, in addition to the above three factors, there are also many factors affecting the

inflation rate (based on Consumer price index - CPI) According to Keynes, besides

the Consumer price index - CPI, cost-push or adaptive expectation are also two factors

leading to inflation As for push costs, it can be simply understood that: When a government cuts taxes or increases recurrent consumption spending, budget deficits and currency devaluation that incur inflation taxes will increase the cost of raw materials Then, the increasing cost of raw materials leads to the bankruptcy of businesses, reducing total supply (potential output) Along with adaptive expectations, inflation is understood as the inherent state of the economy If workers try to keep their wages at the price (above the inflation rate), firms will pass on this higher cost of labor to the customer - through an increase in the prices of goods and services This leads to a loop

of repeating, causing inflation

However, when building the model, we find that three factors: Consumer price index,

Unemployment rate, and Percent change in average weekly earnings greatly affect the

changes of inflation rate According to William Philips, there is an inverse relationship

between the unemployment rate and inflation, through the intermediate factor is the level of food That means if the unemployment rate is low, the economy must create more jobs, businesses expand production and total output increases That also means accepting high inflation and vice versa Therefore, we choose inflation and the factors affecting inflation (Consumer price index - CPI, Unemployment rate, Percent change in average weekly earnings) as the topic for our econometrics report

1 THEOREOTICAL BASIS OF THE RESEARCH TOPIC

1.1 The relationship between inflation, wages and unemployment

The relationship between these three quantities is a two-way relationship and the study focuses on the effects of wages on inflation and unemployment The author admits that

it is impossible to have a perfect relationship between two quantities (one quantity is only affected by the other and vice versa) There are many factors other than wages that influence inflation but certainly the rate of change in wages has a strong effect on inflation

In addition, the author does not deny the impact of unemployment on inflation, but it is

a two-way relationship and both are affected by many other factors

1.1.1 In short-term

A.W.Phillips was one of the first economists to seek to demonstrate a negative correlation between inflation and unemployment Philips has studied extensively on the relationship between the inflation rate and the UK unemployment rate for almost a century (from 1861 to 1957) Eventually he discovered that there was a trade-off between the two

The trade-off of unemployment for wages

His assumption is that the demand for resources increases, labor becomes scarce, businesses will quickly offer higher wages to attract workers However, when the demand for resources decreases and unemployment increases, workers will be reluctant

to accept a salary lower than what they deserve So the rate of wage growth will gradually decrease

The trade-off of wages to unemployment

The second problem that affects the change in wage growth rate is the change in the unemployment rate When the economy thrives, businesses reap great profits, they are willing to pay generous wages in hiring labor This greatly increases the labor supply,

and the unemployment rate then dropped rapidly On the contrary, when the business is not doing well, the salary of employees does not increase or increase very slowly, the demand for labor decreases, the unemployment rate becomes highly

The above assumption by Phillips describes a non-linear relationship between unemployment and wage inflation The curves that form the relationship between the unemployment rate and the overall rate of price inflation (or rather wage inflation) have made the Phillips curve famous The wage inflation data Phillips uses can also be descriptive for general price inflation Because wages are also year in the production costs of the business Raising wages will result in the price of goods and services, and this is also the most basic definition of inflation

1.1.2 Long term

In the late 1960s, a group of economists representing the money major, typically Milton Friedman and Edmund Phelps, gave sharp analysis and criticism that the Phillips curve could not be applied in the long run term In the long run, unemployment will return

The natural adjustment mechanism of the market will return unemployment, this period

is called by Paul Samuelson in the period of stagflation

In the short term, wage increases will attract more workers At this point, the supply of labor will become plentiful, leading to the unemployment rate starting to decline However, workers will gradually find that their wage purchasing power is reduced due

to inflation, and they will offer a higher salary to keep wages up to date The supply of labor thus began to narrow while wage inflation and general price inflation continued

to rise, or even faster than before

Increasing inflation to reduce unemployment is, in the long run, not conducive to the economy Similarly, reducing the inflation rate does not cause the unemployment rate

to rise Since inflation does not affect the long-run unemployment rate, the Phillips curve becomes a vertical line when it intersects the horizontal axis at the value of the natural unemployment rate

1.1.3 Conclusion

The negative correlation between inflation and unemployment in the Phillips curve can only describe the economy in the short run, especially when the inflation rate is in a steady state It cannot be applied in the long run, because the market mechanism will adjust the unemployment rate to its natural rate

The Phillips curve is not a key for the economy, nor can it be applied to “fight against”the unemployment of a country, it can even do harm to the economy

1.2 The relationship between inflation and CPI

Economists often use two indicators to evaluate the inflation rate of the economy: the consumer price index CPI and the total domestic product deflator Here, the CPI represents the fluctuation of a general price level for a basket of consumer end-consumption goods and services

However, according to Investopedia, CPI is not a perfect indicator to measure inflation because of the following factors:

• The quality of goods increases, the price also increases, but the CPI sees that increase as inflation

• The appearance of new goods makes it difficult to compare with old substitutes

• Consumers have many alternatives to where they will buy, but the CPI surveys

do not take these into account

2 MODEL SPECIFICATION TESTING THE INFLUENCE OF UNEMPLOYMENT, CPI, AVERAGE WEEKY EARNINGS

ON INFLATION OF UNITED STATE DURING 1966-2012

2.1 Methodology in the study

2.1.1 Method to derive the model

The process using in the research is called Multiple Linear Regression This is a linear approach to modeling the statistical relatonship of a dependent variable on one or more explanatory variables

2.1.2 Method to collect and analyze the data

2.1.2.1 Collect the data

Collected data are secondary data, in form of Time Series, showing the numerical information of some factors of United State in 47 years from 1966 to 2012 The data was collected base on the data set 2-3 of the book “Introductory Econometrics With Applications by Ramanathan” from the source Economic Report of the President 1995 and 2012 govinfo.gov, which has a very high level of accuracy

2.1.2.2 Analyze the data

Our group has used Stata to analyze the dataset and interpret the correlation matrix between variables

INFL= f(CPI, UNEMP, WGGR)

Where:

• INFL: Percent change in CPI (inflation rate)

• CPI: Consumer Price Index

• UNEMP: Civilian unemployment rate (%)

• WGGR: Percent change in average weekly earnings, in current dollars

Thus, according to the economic theories, in order to analyze the factors influencing the Inflation rate, our group has discussed and decided to choose the regression analysis models

2.2 Population Regression Model

INFL= 1 + 2 *CPI + *UNEMP + *WGGR + U 3 4 i

2.3 Explanation of variables

• Dependent variable INFL: Inflation rate (%)

Inflation happens when the purchasing power of a given currency over time decreases The increase of an average price level of a basket of selected goods and services can reflect the decline in purchasing power

The Inflation rate is the percentage increase or decrease in prices during a specified period, usually a month or a year The percentage tells you how quickly prices rose during the period

Inflation rate t = 100*(CPI t – CPI t-1 )/ CPI t-1

Which:

CPIt : Consumer Price Index this year

CPIt-1: Consumer Price Index last year

• Independent variable CPI: Consumer Price Index (%)

The Consumer Price Index (CPI) is a measure that examines the weighted average of prices of a basket of consumer goods and services, such as transportation, food, and medical care It is calculated by taking price changes for each item in the predetermined basket of goods and averaging them Changes in the CPI are used to assess price changes associated with the cost of living The CPI is one of the most frequently used statistics for identifying periods of inflation or deflation

The formula used to calculate the Consumer Price Index for a single item is as follows:

CPI = 𝐶𝑜𝑠𝑡 𝑜𝑓 𝑀𝑎𝑟𝑘𝑒𝑡 𝐵𝑎𝑠𝑘𝑒𝑡 𝑖𝑛 𝑔𝑖𝑣𝑒𝑛 𝑦𝑒𝑎𝑟

𝐶𝑜𝑠𝑡 𝑜𝑓 𝑀𝑎𝑟𝑘𝑒𝑡 𝐵𝑎𝑠𝑘𝑒𝑡 𝑖𝑛 𝑏𝑎𝑠𝑒 𝑦𝑒𝑎𝑟 * 100 (In the report, the base year is 1983=100)

• Independent variable UNEMP: Civilian Unemployment rate (%)

The unemployment rate is the percent of the labor force that is jobless It is a lagging indicator, meaning that it generally rises or falls in the wake of changing economic conditions, rather than anticipating them When the economy is in poor shape and jobs

are scarce, the unemployment rate can be expected to rise When the economy is growing at a healthy rate and jobs are relatively plentiful, it can be expected to fall The official unemployment rate is known as U-3 It defines unemployed people as those who are willing and available to work, and who have actively sought work within the past four weeks Those with temporary, part-time, or full-time jobs are considered employed, as are those who perform at least 15 hours of unpaid family work

To calculate the unemployment rate, the number of unemployed people is divided by the number of people in the labor force, which consists of all employed and unemployed people The ratio is expressed as a percentage

UNEMP = 𝑈𝑛𝑒𝑚𝑝𝑙𝑜𝑦𝑒𝑑

𝐿𝑎𝑏𝑜𝑟 𝐹𝑜𝑟𝑐𝑒 * 100

• Independent variable WGGR: Percent change in average weekly earnings, in current dollars (%)

• The disturbance term of the model Ui

represents other factors that affect INFL but not mentoned in the model

2.4 Description of the data

2.4.1 Data sources

This set of data was collected based on the data set 2-3 of Ramanthan form the source of Economic Report for President govinfo.gov, includes 47 observations of United States in 47 years from 1966 to 2012

2.4.2 Statistical description of the variables

To get the statistic indicators of the variables, in STATA, we use the command

and receive the table below:

infl 47 4.353191 2.808748 -0.4 13.5 cpi 47 123.7377 62.32767 32.4 229.594 unemp 47 6.148936 1.669401 3.5 9.7

wggr 47 4.104255 1.852021 1.5 8.5

(Source: the team synthesized under the support of Stata software)

According to the statistic table above, we can see that almost all the Standard Deviation (Std.Dev) is much smaller than the mean, the value of maximum and minimum is quite far, this means the statistic distribution is absolutely large It happens since the data is updated each year and collected in long period On the other hand, these data are sensitive to other factors such as society, economy, politics, Due to this, the reflection of changing in the dependent variable may not get high confident

2.4.3 Correlation matrix between variables

The correlation coefficient measures the strength and directioin of a linear relationship between two variables on a scatter plot In STATA, the correlation with matrix is generated by using the command

corr infl cpi unemp wggr

to check the correlation between the variables, we have the result as the table below:

Table 2 Correlation matrix

infl 1.0000

cpi -0.5597 1.0000

unemp 0.0740 0.1800 1.0000

wggr 0.7194 -0.6443 -0.0279 1.0000

(Source: the team synthesized under the support of Stata software)

According to the matrix, it can be inferred