Author Question: Money supply is linked to the monetary base by the money multiplier. Macroeconomic textbooks tell ... (Read 852 times)

xroflmao · **on:** Jun 29, 2018

Money supply is linked to the monetary base by the money multiplier. Macroeconomic textbooks tell you that the central bank cannot control the money supply, but it can control the monetary base.

As a result, you decide to specify a distributed lag equation of the growth in the money supply on the growth in the monetary base. One of your peers tells you that this is not a good idea for modeling the relationship between the two variables. What does she mean?
What will be an ideal response?

Question 2

To estimate dynamic causal effects, your textbook presents the distributed lag regression model, the autoregressive distributed lag model, and a quasi-difference representation of the distributed lag model with autoregressive errors.

Using a simple example, such as a distributed lag model with only the current and past value of X and an AR(1) model for the error term, discuss how these models are related. In each case suggest estimation methods and evaluate the relative merit in using one rather than the other.
What will be an ideal response?

harveenkau8139 · **Reply #1 on:** Jun 29, 2018

Answer to Question 1

Answer: Although the monetary base is one of the determinants of the money supply, there are other factors, such as interest rates, that have an effect on the money multiplier. Hence there is the problem of omitted variables. If interest rates are correlated with the monetary base, then the OLS estimator will be inconsistent. Furthermore, it is likely that due to financial innovations, dynamic causal effects have changed over time. Finally there is the concern of simultaneous causality bias. If the Federal Reserve changes the monetary base as a result of changes in the money supply, perhaps as a result of targeting, then the monetary base becomes endogenous.

Answer to Question 2

Answer: The student's answer should follow the discussion in section 13.2-13.3 (distributed lag model) and 13.5 (autoregressive distributed lag model and quasi-difference representation of the distributed lag model with autoregressive errors). Major points which should include the assumption of exogeneity in the case of the distributed lag model, which, together with the other distributed lag model assumptions, allows for the dynamic multiplier and cumulative dynamic multiplier estimation by OLS. Given the AR(1) nature of the error term, the importance of using HAC standard errors should be stressed.

For the ADL and quasi-difference representation, the importance of the strictly exogenous regressor assumption must be emphasized. The answer should include the derivation of the dynamic multipliers from the OLS estimated ADL coefficients and the difference between the infeasible and feasible GLS estimator. For the latter, the Cochrane-Orcutt procedure should be mentioned.

If the regressors are strictly exogenous, then GLS is asymptotically BLUE. However, since the ADL specification requires estimation of fewer parameters, it may be preferred in practice. If there is no convincing argument for the regressor being strictly exogenous, but an argument for exogeneity can be made, then OLS estimation using HAC standard errors is the preferred method.