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Analysis of the Taylor Principle in Explaining Inflation in Canada

## Data Project

Description of the project

The data project is about the Taylor principle and whether this theory can explain the rise of inflation in the 1970s and the subsequent fall in inflation in the 1980s and after in Canada. Use Canadian data, argue for or against the following hypothesis: “The rise in inflation in the 1970s in Canada is due to a failure of adhering to the Taylor Principle. Monetary policy was passive in the 1970s. On the other hand, the fall in inflation in the 1980s and after is because the central bank adhered to the Taylor principle and implemented an active monetary policy.”

-Using data from Statistics Canada, divide your sample into two periods. 1962Q1-1979Q4 and 1980Q1 and 2021Q2 and estimate the equation below (The Taylor rule) for the two sample periods using OLS it = i∗ + γππt + γx(yt − ?yt) (1).

• where it is the nominal interest rate at time t, i∗, the equilibrium nominal interest rate, πt the year-over-year inflation rate (in percent), yt, the log of real GDP and ?yt, the log of real potential GDP. Hence (yt − ?yt) is the output-gap (in percent).

• Use the following data from Statistics Canada (download your data from Jan 1960 to June 2021 if it is monthly and from 1960Q1 to 2021Q2 if it is quarterly)

– Consumer Price Index, All-items monthly, not seasonally adjusted, Table: 18-10-0004-01. You have to calculate the year over year inflation and then convert the data from monthly to quarterly

– Treasury bill auction - average yields: 3 months, Table: 10-10-0122-01. You have to convert the data to quarterly

– Download the output-gap series from Learn under the Data project tab. Note that the output-gap is calculated using a Hodrick-Prescott filter. The data is quarterly and runs from 1961Q1 to 2021Q2.

i) Why should the coefficients on inflation and the output gap be positive? Explain briefly.

(ii) How large should the coefficient on γπ be to satisfy the Taylor principle?

(iii) Based on your estimation, do you find evidence in favour or against the hypothesis? Explain your empirical findings carefully (for example, what is the value of γπ and γx? Are the coefficients significant? Are your surprised by their sign and magnitude?

(iv) If you find support for the hypothesis, using the New Keynesian model, explain how violating the Taylor principle led to the rise in inflation in the 1970s and adhering to the Taylor principle to the fall in the 1980s.

(v) Is the above hypothesis the only one you can think of to explain the rise and fall of inflation in Canada during this period? If not, what other views/hypothesis can you put forward?

1.Your answers to the above question should not exceed three pages (double-line).

2.Output from your regressions or construct a table to present the output from your regressions.