Applied Econometrics

This document provides a comprehensive analysis of factors affecting inflation rate in United Kingdom. It includes a literature review on inflation and its relation with economic growth, unemployment, interest rate, and money supply growth. The document also presents an econometric model and regression analysis to estimate the impact of these factors on inflation rate. Hypothesis testing and diagnostic testing are also conducted to validate the results.

Running head: APPLIED ECONOMETRICS
Applied Econometrics
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1APPLIED ECONOMETRICS
Table of Contents
1.0Introduction.................................................................................................................................2
2.0 Literature Review......................................................................................................................2
2.1 Inflation and economic growth..............................................................................................2
2.2 Inflation and Unemployment.................................................................................................2
2.3 Inflation and interest rate.......................................................................................................3
2.4 Inflation and money supply growth.......................................................................................3
2.5 Econometric model................................................................................................................3
2.6 Hypotheses.............................................................................................................................4
3.0 Result estimation.......................................................................................................................5
3.1 Descriptive Statistics.............................................................................................................5
3.2 Correlation coefficient...........................................................................................................6
3.3 Regression..............................................................................................................................7
3.4 Hypothesis testing..................................................................................................................8
3.5 Diagnostic testing..................................................................................................................9
3.5.1 Multicollinearity.............................................................................................................9
4.0 Conclusion.................................................................................................................................9
5.0 References................................................................................................................................10

2APPLIED ECONOMETRICS
1.0Introduction
Inflation is a measure of average price level of an economy. It is defined as a
phenomenon of overtime increase in the average price level. Rate of inflation plays an important
role in determining real value of money. Increase in price level means a lower value of money in
real terms which in turn implies a lower purchasing power. Inflation may have serious negative
influence on economic growth of a nation. Higher inflation means a higher cost of living.
Inflation is commonly measured by a percentage change in Consumer Price Index between two
consecutive periods (Heijdra 2017). Inflation also affects the real interest rate and other
macroeconomic variables. Following serious consequences of inflation in an economy study of
inflation has become one important area of research.
The current paper conducts an empirical analysis on factors affecting inflation rate in
United Kingdom. The historical trend of inflation rate in UK reveals that the country has
recorded a rapidly declining trend in price level. Inflation rate remained at 2.1 percent since the
past few years. The paper has studied inflation rate and associated factors for a period from 1988
to 2017. All the relevant data has been collected from the official website of world bank and
office for national statistics.
2.0 Literature Review
Researchers show significant interest in studying factors affecting inflation rate in an
economy. Depending on theoretical and empirical literatures the factors that are taken into
consideration to influence inflation in UK are – GDP growth, Unemployment rate (UNEMP),
Interest rate (INT) and Broad money growth (MS).
2.1 Inflation and economic growth
A gradual increase in price level is termed as inflation. Increase in the average price level
is often due to a faster economic growth. There is are also situations where inflation is associated
with a weak economic growth. In general, a stronger economic growth is associated with a
higher rate of inflation. If an economy experiences faster expansion in aggregate demand relative
to aggregate supply, then prices move upwards (Ibarra and Trupkin 2016). When demand
increases at a faster rate than the available supply, then the economic growth rate exceeds the
long run sustainable growth rate. In the phase of rapid economic expansion, the economy can
experience an inflationary pressure. This is due to following two reasons. Firstly, with faster
growth, demand expands faster than supply. The resulted supply shortage leads to a higher price.
Secondly, higher growth means more employment opportunities. With increase in labor demand
there is an immediate labor shortage resulting in a higher wage for existing workers. Inflation
may also result from the increase in wages (Islam et al. 2017). However, economic growth can
also be realized without sustained increase in the price level. If the economic growth is close to
its long run growth and demand increases in line with supply, then price level decreases or
remain same despite higher economic growth.
2.2 Inflation and Unemployment
Unemployment rate in general assumed to have an inverse relation with rate of inflation.
Theoretical explanation for this inverse relation has been given by Phillips curve theory. This
states that as unemployment increases, there is a decrease in inflation rate and vice-versa. The
trade-off between inflation and unemployment is described by Phillips curve. Past papers

3APPLIED ECONOMETRICS
conducting research on inflation and unemployment confirmed the trade –off relation between
inflation and unemployment (Bhattarai 2016). A study using data of Brazil validated the
proposition of Phillips curve. Research on Malaysia using data from 1973 to 2004 also found
similar result. The paper tested Johansen co-integration between inflation and unemployment.
The result concluded that there exists a long-run inverse relation between inflation and
unemployment (Pradhan, Arvin and Bahmani 2015). There are also several other studies that
found the similar result.
2.3 Inflation and interest rate
Interest rate is defined as the reward that people get from their saved or invested funds.
There is debate over the relation between inflation and interest rate given the general state pf the
economy. The Fisher hypothesis suggests that there is a positive relation between inflation and
interest rate (Harswari and Hamza 2017). Inflation and interest rate are related as they both are
money driven factors and influence both demand and supply side of an economy. Interest rate is
the cost of borrowing. As interest rate increases, investors face a higher borrowing cost which
discourages investment. As investment falls aggregate demand falls as well resulting in a decline
in inflation (Saymeh and Orabi 2013). In this sense, interest rate is inversely associated with
inflation. For this reason, most nations use interest rate as an effective tool to control inflation.
One study found a long run relationship between inflation and interest rate. One paper concluded
that there is a two-way relationship between interest rate and inflation (Ayub et al. 2014). Some
studies however contradicted these finding and concluded that no long term relation exist among
them.
2.4 Inflation and money supply growth
Growth in money supply and inflation rate are likely to be positively related. The relation
between money supply growth and inflation depends on money supply and money demand.
Increase in the supply of money increases rate of growth in money which in turn likely to
increase rate of inflation in an economy. There is thus a positive relation between growth of
money supply and inflation rate (Ball 2017). Past studies showed high positive correlation
between inflation and money supply. One study had been conducted to evaluate the relation
between money supply and inflation using time series data of 13 countries. The study found that
inflation rate in an economy occurred due to increases in money supply in that particular
economy (Hung. and Thompson 2016). Most studies found a positive or direct long term
relationship between money supply growth and inflation rate. As money supply in the money
market increases, there is an increase in demand for goods and services (Denbel, Ayen and
Regasa 2016). Since more amount of money chases the fewer amount of goods and services,
there is an increase in price level or inflation.
2.5 Econometric model
The paper builds an econometric model where inflation rate is considered as a function of
GDP growth rate, unemployment rate, interest rate and broad money supply growth rate.
Inflation can therefore be expressed as
INF=f (GROWTH ,UNEMP ,∫, MS)
INF: Inflation rate

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GROWTH: GDP growth rate
UNEMP: Unemployment rate
INT: Interest rate
MS: Broad money supply growth rate.
The research has done using the regression method based on the real world data. There is some
uncertain event that might influence inflation rate in the economy. The uncertain factors are
considered as error term. Data has been collected for the period from 1988 to 2017. The model
can be specified as
INFt=α0 +α 1 GROWTH t +α 2 UNEMPt + α3 ∫¿t + α4 MSt + εt ¿
In the above model, the dependent variable is INFt. The independent variables are GROWTHt,
UNEMPt, INTt and MSt. α1, α2 α3 and α4 are the respective coefficients of GROWTHt, UNEMPt,
INTt and MSt. ε t is the error term.
2.6 Hypotheses
Depending on the research aim and past literatures following four hypotheses are
developed
Inflation
GDP Growth
(Indeterminant)
Unemployment
(Negative)
Interest rate
(Indeterminant)
Broad Money
Supply Growth
(Positive)

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Hypothesis 1
Null Hypothesis (H0): β1=0(There exist no significant relation between INF and GROWTH)
Alternative Hypothesis (HA): β1 ≠ 0(There exists a statistically significant relation between INF
and GROWTH)
Hypothesis 2
Null Hypothesis (H0): β2 ≥ 0(There exist neither significant nor negative relation between INF
and UNEMP)
Alternative Hypothesis (HA): β2<0(There exists a negative significant relation between INF and
UNEMP)
Hypothesis 3
Null Hypothesis (H0): β3=0(There exist no significant relation between INF and INT)
Alternative Hypothesis (HA): β3 ≠ 0(There exists a statistically significant relation between INF
and INT)
Hypothesis 4
Null Hypothesis (H0): β4 ≤ 0(There exist neither significant nor positive relation between INF
and MS)
Alternative Hypothesis (HA): β4 >0(There exists a positive significant relation between INF and
INT)
3.0 Result estimation
3.1 Descriptive Statistics
Table 1: Summary statistics of INF, GROWTH, UNEMP, INT and MS

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The above summary statistics shows that average growth rate in United Kingdom, for the
last thirty years is 2.13 percent. For the given period highest and lowest growth rate are 5.75
percent and -4.19 percent respectively.
The summary statistics shows that average inflation rate in United Kingdom, for the last
thirty years is 2.74 percent. For the given period the maximum and minimum inflation rate are
8.06 percent and 0.36 percent respectively.
From the descriptive statistics, average broad money supply growth rate in United
Kingdom, for the last thirty years is obtained as 8.10 percent. In the sample period the highest
and lowest money supply growth rate are 25.50 percent and -28.63 percent respectively.
The above summary statistics shows that average interest rate in United Kingdom, for the
last thirty years is 1.95 percent. The highest and lowest interest rate for the given period are 6.38
percent and -3.71 percent respectively
The descriptive statistics reveals that average unemployment rate in United Kingdom, for
the last thirty years is 6.81 percent. For the given period the maximum and minimum
unemployment rate are 10.40 percent and 4.40 percent respectively.
3.2 Correlation coefficient
Table 2: Correlation coefficient between INF, GROWTH, UNEMP, INT and MS
The above correlation matrix shows degree of association between inflation, GDP
growth, unemployment, interest rate and broad money supply growth rate. The correlation
coefficient between inflation rate and GDP growth rate is found to be -0.31. The negative
coefficient of correlation indicates an inverse association between inflation and growth. For
money supply growth, correlation between inflation and money supply growth is -0.07. The
correlation coefficient indicates a weak negative association between inflation and money supply
growth (Fox 2015). In case of interest rate and unemployment the coefficient of correlation
between inflation rate and the two respective variables are 0.44 and 0.47 respectively. This
means inflation rate has a positive and moderate association with these two variables.

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3.3 Regression
Table 3: Eviews result of regression estimation
Depending on the regression output, the computed model can be stated as
^INFt=−0.080−0.388 GROWTH t + 0.425UNEMPt +0.2645+0.029 MSt
The interpretation of the respective regression coefficient is presented in the following table
Table 4: Interpretation of regression coefficient
Coefficient Interpretation
-0.388Growtht A 1 percent in increase in GDP growth in United Kingdom lowers inflation rate
by 0.39 percent
0.425UNEMPt A 1 percent in increase in unemployment in United Kingdom increase inflation
rate by 0.43 percent
0.265INTt A 1 percent in increase in interest rate in United Kingdom increases inflation
rate by 0.27 percent
0.029MSt A 1 percent in increase in broad money supply growth in United Kingdom
increases inflation rate by 0.03 percent
The regression result gives an unexpected sign for unemployment rate as a determining
factor of inflation. Both theoretical and empirical literatures found an inverse association relation
between inflation and unemployment. The estimated regression however shows a positive
association between inflation and unemployment.

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The value of adjusted R square is 0.40. This implies GDP growth, unemployment,
interest rate and broad money supply growth account only 40 percent variation in occurred in the
inflation rate of United Kingdom. The overall significance of the model can be tested from the
value of F statistics. The probabilistic value for F statistics is 0.0017. As the value is less than
significance value of 0.05, the model is significant at 5 percent level of significance. GDP
growth, unemployment rate and interest rate are stronger determinants of inflation rate as the
probabilistic value is smaller than 0.05 (Darlington and Hayes 2016). Money supply growth on
the other hand is a weak determinant as the probability value is greater than 0.05.
3.4 Hypothesis testing
Hypothesis resting is used to examine the statistical significance of obtained regression
result. For this purpose, t test has been used. The decision rule is rejection of null hypothesis if
obtained t value from the regression exceeds the value of critical t (Schroeder, Sjoquist and
Stephan 2016).
t= Coefficient
Standard error
The degrees of freedom for the ‘t’ test can be determined as
DF =Number of observation−number of parameters−1
¿ 30−4−1
¿ 25
The results of hypothesis testing are summarized in the following table
Table 5: Result of Hypothesis testing
Variable GROWTH
( β1 )
UNEMP
( β2 )
INT
( β3 )
MS
( β4 )
Hypothesis H0 : β1=0
H1 : β1 ≠ 0
H0 : β2 ≥ 0
H1 : β1 <0
H0 : β3=0
H1 : β3 ≠ 0
H0 : β4 ≤0
H1 : β4 >0
Computed t
statistics ¿ ¿)
|-2.4769| 2.6594 2.8582 1.0142
Critical t value
¿ ¿)
2.0595 1.7081 1.7081 2.0595
Decision rule t0 >tc
Reject H0.
That is there
exists a
statistically
significant
relation
between INF
and
GROWTH.
t0 >tc
Reject H0. That
means there is a
negative
significant
relation between
INF and
UNEMP
t0 >tc
Reject H0. That
means there
exists a
statistically
significant
relation between
INF and INT.
t0 <tc
Accept H0. There
is no positive
significant
relation between
INF and MS

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3.5 Diagnostic testing
3.5.1 Multicollinearity
The problem of multicollinearity is said to exits of there is a considerably strong
correlation between the independent variables of a regression model. The presence of strong
multicollinearity leads to redundant information affecting the accuracy of the model. OLS
estimates give biased result if predictor variables are perfectly correlated (Disatnik and Sivan
2016). In order to detect multicollinearity, Variance Inflation Factors is used. Value of VIF
greater than 5 means a strong multicollinearity.
Table 6: Eviews result of VIF
The coefficient diagnostic test gives estimated VIF for each of the regression coefficient
as less than 5. Following the rule of thumb for multicollinearity detection, it can therefore be said
that for the built model multicollinearity is not a serious problem.
4.0 Conclusion
The research paper aims to examine the relation between inflation rate and that of GDP
growth, unemployment rate, interest rate and broad money supply growth rate. The results show
GDP growth has a negative significant relation between GDP growth. One reason for the inverse
relation between economic growth and inflation is the active intervention if Bank of England to
stabilize the price level. Unemployment is found to have a negative significant relation with
inflation as explained by Phillips relation. For interest rate also the relation between inflation and
interest rate is positive and significant. The estimated result shows that money supply has a
positive relation with inflation rate as proposed by theory and empirical literatures. However, no
firm conclusion can be made as the variable is statistically insignificant.
First limitation of the paper is inability to extend the sample period due to restricted
availability of data. For unemployment, sign of the regression coefficient is opposite to that
suggested from past literatures. The variable money supply growth is statistically insignificant
implying no policy suggestion can be made regarding this variable. This is another limitation of
this paper.

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5.0 References
Ayub, G., Rehman, N.U., Iqbal, M., Zaman, Q. and Atif, M., 2014. Relationship between
Inflation and Interest Rate: Evidence from Pakistan. Research Journal of Recent Sciences, 3(4),
pp. 51-55.
Ball, R.J., 2017. Inflation and the Theory of Money. Routledge
Bhattarai, K., 2016. Unemployment–inflation trade-offs in OECD countries. Economic
modelling, 58, pp.93-103.
Darlington, R.B. and Hayes, A.F., 2016. Regression analysis and linear models: Concepts,
applications, and implementation. Guilford Publications.
Denbel, F.S., Ayen, Y.W. and Regasa, T.A., 2016. The relationship between inflation, money
supply and economic growth in Ethiopia: Co integration and Causality Analysis. International
Journal of Scientific and Research Publications, 6(1), pp.556-565.
Disatnik, D. and Sivan, L., 2016. The multicollinearity illusion in moderated regression
analysis. Marketing Letters, 27(2), pp.403-408.
Fox, J., 2015. Applied regression analysis and generalized linear models. Sage Publications.
Harswari, M. H. A. B. N., & Hamza, S. M., 2017. The Impact of Interest Rate On Economic
Development: A Study On Asian Countries. International Journal of Accounting & Business
Management, 5(1)
Heijdra, B.J., 2017. Foundations of modern macroeconomics. Oxford university press.
Hung, H.F. and Thompson, D., 2016. Money supply, class power, and inflation: Monetarism
reassessed. American Sociological Review, 81(3), pp.447-466.
Ibarra, R. and Trupkin, D.R., 2016. Reexamining the relationship between inflation and growth:
Do institutions matter in developing countries?. Economic Modelling, 52, pp.332-351.
Islam, R., Ghani, A.B.A., Mahyudin, E. and Manickam, N., 2017. Determinants of factors that
affecting inflation in Malaysia. International Journal of Economics and Financial Issues, 7(2),
pp.355-364.
Pradhan, R.P., Arvin, M.B. and Bahmani, S., 2015. Causal nexus between economic growth,
inflation, and stock market development: The case of OECD countries. Global Finance
Journal, 27, pp.98-111.
Saymeh, A.A.F. and Orabi, M.M.A., 2013. The effect of interest rate, inflation rate, GDP, on real
economic growth rate in Jordan. Asian Economic and Financial Review, 3(3), p.341.
Schroeder, L.D., Sjoquist, D.L. and Stephan, P.E., 2016. Understanding regression analysis: An
introductory guide (Vol. 57). Sage Publications.