ECON 2300: It is argued that output may be endogenous: Introductory Econometrics Assignments, VU, Australia

Problem 1: money, Growth, and Inflation 

Background

To examine the quantity theory of money, Brumm (2005) [“Money Growth, Output Growth, and Inflation: A Reexamination of the Modern Quantity Theory’s Linchpin Prediction,” Southern Economic Journal, 71(3), 661–667] specifies the inflation equation inflate = β1 + β2money + β3output + u where inflation is the growth rate of the general price level, money is the growth rate of the money supply, and output is the growth rate of national output. Economic theory suggests that β2 = 1 and β3 = −1. The dataset Brumm.dta consists of 1995 data on 76 countries.

Research tasks
1. It is argued that output may be endogenous. Four instrumental variables are proposed, initial = initial level of real GDP, school = a measure of the population’s educational attainment, inv = average investment share of GDP, and populate = average population growth rate.

(a) Give an intuitive explanation as to why output can be endogenous

(b) Explain why the proposed IVs can be valid.

2. Using the four IVs, obtain TSLS estimates of the inflation equation and test the economic theory using the IV estimates.

3. Determine whether the IVs are strong or not and test if they are exogeneous.

4. Present a short research note of your findings. You are allowed to use your previous findings here again or to estimate again the model using a different set of IVs

Problem 2: Demand for Democracy

Background:

Do citizens demand more democracy and political freedom as their incomes grow? That is, is democracy a normal good? To investigate this issue, you will explore the dataset Income Democracy.dta which contains a panel data set from 195 countries for the years 1960, 1965, …, 2000.

The dataset contains an index of political freedom/democracy for each country in each year, together with data on the country’s income and various demographic controls.

Research tasks:

1. Is the data set a balanced panel? Explain.

2. The index of political freedom/democracy is labeled dem ind.

(a) What is the value of dem ind for the United States in 2000? What is the average of dem ind for the United States overall years in the data set? (4 marks) Repeat this exercise for Libya

(b) List five countries with an average value of dem ind greater than 0.95; less than 0.10; and between 0.3 and 0.7.

3. The logarithm of per capita income is labeled log gdppc .

(a) Regress dem ind on log gdppc using standard errors that are clustered by country

(b) How large is the estimated coefficient on log gdppc? Is the coefficient statistically significant?

(c) If per capita income in a country increases by 20%, by how much is dem ind predicted to increase? What is a 95% confidence interval for the prediction? Is the predicted increase in dem ind large or small? Explain what you mean by large or small.

(d) Why is it important to use clustered standard errors for the regression? Do the results change if you do not use clustered standard errors?

4. (a) Suggest a variable that varies across countries but plausibly varies little–or not at all–over time and that could cause omitted variable bias in the regression in Question 3 above.

(b) Estimate the regression in Q3, allowing for country fixed effects.

(c) Exclude the data for Azerbaijan and rerun the regression. Do the results change? Why or why not?

(d) Suggest a variable that varies over time but plausibly varies little–or not at all–across countries and that could cause omitted variable bias in the regression in Q3.

5. Based on your analysis, what conclusions do you draw about the effects of income on democracy?