Applied Econometrics

Running head: APPLIED ECONOMETRICS
Applied Econometrics
Name of the Student
Name of the University
Course ID
Student ID

APPLIED ECONOMETRICS1
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

APPLIED ECONOMETRICS2
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

APPLIED ECONOMETRICS3
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