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Keynesians vs monetaristsA Granger Causality match
Guy Lion April 2006
Hey Keynes, your [Tax] Cuts
are no uppercut.
Milton, where is your [Money]
Velocity?
I am Clive Granger who
decides Causality
2
Introduction
We will use Granger causality to referee a match in economic theory between Keynesians and monetarists.
Both claim their respective tools are best to manage GDP. We will test which tools better “Granger cause” quarterly
GDP changes.
3
Keynesian economics
John Maynard Keynes (1883 – 1946) stated that a counter-cyclical fiscal policy was effective in managing the business cycle.
This means running a Budget Deficit when the economy is decelerating. And, running a Budget Surplus when economy is accelerating.
Keynes suggested government (net) spending affected aggregate demand without affecting price (inflation).
4
Monetarism
Milton Friedman (1912 - ) stated the Money Supply has a direct impact on economic growth and inflation.
Milton relied on Irving Fisher’s (1867–1947) Quantity Theory: MV = PQ or Money Supply x Velocity of Money = Price x Quantity.
The best way to manage the economy is to target a conservative Money Supply growth and stick to it. This way, you control inflation.
5
Keynesians vs Monetarists fighting stands
Keynesians do not believe monetary variables (M1, M2, M3) affect macroeconomic variables (GDP, CPI). This may be due to change in Velocity of Money being a countervailing force to change in Money Supply. Thus, for them “money does not matter.”
For monetarists, fiscal policies are not effective because interest rate is a countervailing force to fiscal stimulus (the “crowding out” theory). And, because of the Quantity Theory [MV = PQ] Money Supply does have a direct impact on macroeconomic variables (GDP, CPI). Thus, for them “money is everything.”
6
A Budget Deficit proxy variable
Budget Deficit data is annual. That’s a problem. As an alternative we looked at Treasury levels from one
quarter to the next. Disaggregate Interest refinancing from Deficit financing
as shown below.
10 yr rate 10%
DeficitTreasury Increase Interest Deficit financing
levels in T level refinancing financing in %Q1 1000Q2 1050 50 25 25 2.5%
7
Granger Causality review
1. Develop a Base case autoregressive model using dependent variable and its lagged values as independent variable.
2. Develop a Test case model by adding a second lagged independent variable you want to test.
3. Calculate the square of the residual errors for the two models and run a t test (unpaired) to check if the residuals are significantly lower when you add tested second variable. [We will run the non-parametric Mann-Whitney test to observe P value differences].
4. Redo steps 1 through 3, but reverse the direction. By comparing the tests significance or P value, you can see if A Granger causes B more than B Granger causes A.
We will skip step 4 because we are not interested on whether GDP impacts fiscal or monetary policies, but on whether fiscal or monetary policies have a greater impact on GDP.
8
Selecting the lagged variable for GDP
Data source: quarterly data since second quarter 1959 to 3d quarter 2005. Source: BEA (GDP), Flow of Funds (Treasury -> Deficit Financing), Federal Reserve (M2).
Correlation with quarterly GDP
KeynesDeficit Milton
financing M2Spot (0.03) 0.10 Lag 1 Q 0.17 0.17 Lag 2 Q 0.29 0.26 Lag 3 Q 0.15 0.21 Lag 4 Q 0.10 0.14
9
Granger Causality GDP Output
Keynes or Milton Granger causing GDP growthBase Test model
Model Keynes MiltonRegression statisticsMultiple R 0.212 0.361 0.319R Square 0.045 0.131 0.102Adjust. R Square 0.040 0.121 0.092Standard Error 0.008 0.008 0.008Observations 184 184 184
t testAvg. residual square 7.0E-05 6.4E-05 6.6E-05p value 62.8% 75.2%
Mann-Whitney testDifference in avg. rk -4.4 6.4p value 69.4% 56.5%
P values for both test models are too high.
In the Mann-Whitney test, the Milton model is going in the wrong direction. The avg. rank went up. That’s bad.
10
Keynes vs Milton slugfest
Keynes vs Milton. A direct comparison of squared residuals
Keynes Miltont testAverage Square residual 6.41E-05 6.62E-05Difference in " " " -2.12E-06P value 86.5%Confidence Keynes is better 13.5%
Mann-Whitney testAverage rank 179 190Difference in avg. rank -11P value 32.3%Confidence Keynes is better 67.7%
11
Conclusion
[Milton to Granger] I feel tired right now.
Keynes wins by Granger
causing decision.
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