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Sep 15, 2011 | #1
Economics and Financial Economics
Masters Level Dissertation
(Course): Economics and Financial Economics
(Module):
12000 words
1. Outline and Introduction - 3 AUG
2. Literature Review & Methodology - 11 AUG
3. All done - 21 AUG
Topic: The Monetary Policy determinants on the Unemployment in the UK...Use Structual VAR approach
- Introduction
- Literature review : include and compare different models
- Methodology : probably VAR approach
Collect data (UK)
Run data (eg: use Eviews/ Stata software)
Show result and interpret (include figures and graphs)
- Robustness: other variables
- Conclusion
- Reference: Harvard system
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Provisional Brief Outline:
1. Introduction
2. Literature Review: include and compare different theories and models (details in the file guidelines of dissertation)
3. Model: collect different models, choose the model, identify model... Real business cycle, Keynesian model, classic model...
4. Data: Collect data (UK) eg: Recourse IMF, National Statistics...
5. Methodology: probably VAR approach
6. Result: Run data (eg: use Eviews/ Stata software)
Show result and interpret (include figures and graphs)
7. Robustness: other variables and find sth which didn't write or use in the previous part...
8. Conclusion
9. Reference: Harvard System
Note:
1. Resource: should include the resource of data, graphs, regression output and other references.
2. Acknowledge: appreciate if author can provide some brief procedures of running data by economics software, since I need to discuss with supervisor.
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The monetary Policy Determinants on the Unemployment in the United Kingdom
Contents
Chapter One: Introduction 1
1.1 Research Background 1
1.2 Research Aims and Objectives 3
1.3 Significance of the research paper 3
1.3 Research Questions 4
Chapter Two: Literature Review 6
Chapter Three: Research Methodology 17
3.1 Research Design 17
3.2 Primary Data Collection Method 17
3.2.1 Analysis through the Primary Data 18
3.2.1a General form of the Equation 18
3.2.1b Hypothesis 20
3.2.1c Decision Rule 20
3.2.1d Expected Results 20
3.3 Secondary Data Collection 21
3.3.1 Source of Secondary Data 22
3.4 Ethical Issues taken Into Account 22
3.5 Reliability Credibility and Generalizability of the Research Paper 22
Chapter Four: Data Analysis 25
Regression Analysis: Unemployment versus change in RPI, Bank Interest, m4 25
Regression Analysis: Change in Unemployment versus m4 31
Regression Analysis: Unemployment versus m4 31
Regression Analysis: m4 versus Bank Interest rates, RPI 32
Regression Analysis: Bank Interest rates versus m4 32
Chapter Five: Conclusion 34
Chapter One: Introduction
1.1 Research Background.
BBC News (2011) reported that unemployment in the United Kingdom as of May 2011 stood at 2.45 million people, as calculated by the Office of national statistics. Out of a 62, 262, 000 population, this number of people basically showed that around 7.7% of the population in the United Kingdom faces the wrath of unemployment (Office of national Statistics, 2011). With the constant increase in the cost of living in the country and especially an increase in the world food and energy prices, this figure basically shows that around 8% of the population in the United Kingdom is in serious financial and economic trouble.A portion of credit for these statistics goes to the housing sector of the United States, which led to a major financial and credit crunch internationally. Financial experts, consultants, equity holders and other investors, who had their money in the apparent blossoming housing and manufacturing sector of the United States, were forced to withdraw their money, hence further aggravating the problem. The result for the situation is very well known by all; the occurrence of Great Recession and people actually stating that everything felt like the recession in 1980s.
It is understandable, that efficient management of an entity is not always the key for the success and growth of it and that more often than a person would like it, external factor influence and actually determine the fate of the entity. When one is talking about an entire economy, concerned and affected by an entire meshwork of financial, economic, political and social systems the level of effect that external factors have is amazingly high. One of the reasons for the fact being true then is fairly simple but highly effective. It deals with the fact that organizations, trading and financial processes are more globally integrated today than ever. This being true has its perks such as a larger global market for the organizations, more resources to be exploited and then a better diversification of risks, but the same process is not free of the threats and challenges that it serves to the users. A problem in one system in one location, through the ripple effect influences the fate and success of other systems across the globe (whether in a positive manner or negative).
It has been achieved that an economy is highly affected by the external factors. But as mentioned above, efficient management of the economy is a factor of no less importance. Moreover, efficient management, altered as per requirement under the light of external factors can sometimes very well shield the entity from greater damage. This established, the point of high unemployment in the United Kingdom, affecting and threatening the welfare of many people in the country is brought into focus again. The issue that will be raised under the light of the discussion above is the question as to how my unemployment in the country is actually credible to the accounts of management of the economy.
More simply said, the question that is asked is whether this high rate of unemployment is the result of some mismanagement, or miscalculation of the government or the policy makers of the United Kingdom.
Considering the vastness of the issue because of a number of factors and aspects of management, one chosen for the purpose of this paper is the monetary management of the United Kingdom (the monetary policy).
The study of economics throughout its stretch (and by all almost all schools of thought of economics) emphasizes on the importance of monetary policy of an economy and the resulting effects that it has on the other variable of the economy. The monetary policy of an economy, very often leads to an alteration of the aggregate demand in an economy, thus shifting the equilibrium of the country to a different (higher or lower) output level. A different output level then means a different rate of unemployment in the country. Thus, taking out all other variable from in between, monetary policy has the power to influence the unemployment rates in the country.
The clichéd definition of inflation "too much money chasing too few goods", as noted by Mankiw (2008) then, also concerns the monetary policy. Again, through the Phillips curve, the fact that there is a significant relationship between unemployment and inflation is very much visible and can be analyzed and broken down into various elements for study. So basically, the issue raised is that monetary policy (both as a whole and as broken down into various elements) has a strong role to play in the determination of unemployment rates (and employment opportunities as a reciprocal in the country).
This paper then is going to be focusing on precisely this issue but as studied for the case of the United Kingdom. The following sections will provide a guideline to the orientation of the research paper in terms of the aims and objectives, the significance of the research paper along with its scope and the research questions.
1.2 Research Aims and Objectives
The basic aim of constructing this research paper is to understand how much of the unemployment threat to the lives of the people and the welfare of the overall economy is credible to the account of monetary policy makers in the country and to find out how, if differently handled, the United Kingdom's economy would be in a different position. Through a sound review of academic literature, this research paper is aimed at finding out the theoretical underpinnings of unemployment, monetary policy and their relation. And finally, this research paper is aimed at reaching a soundly, empirically supported conclusion and providing subjective but worthy recommendations for the matter.
Furthermore, the objective for the creation of this research paper is to provide some substantial input in the academic and research world and to be able to return in the arena of academic literature at least some portion of what has been taken in the first place throughout the course of studying.
1.3 Significance of the research paper
The significance of monetary policy for an economy has been under a lot of debate with the monetarist school of thought arguing in favor of it and the classical school of thought fighting against the system. Nonetheless, the monetary policy is a very important and high sought after tool for the governments and policymakers of almost all the economies of the world. The basic functions of monetary policy and how important the levels of money are have been explained in the literature review of this paper. The levels of money in the economy have a number of implications for the overall system and the resulting management that is put into application for the economy. One important relationship, as mentioned in the section above is that of the monetary policy and rate of unemployment in an economy. That relationship then again, is precisely the reason for the creation of this research paper. The research paper is significant in crafting out and discussing the relationship between the monetary policy and unemployment. As many econometrics functions, this relationship is simultaneous and endogenous in nature and one variable in actually linking with a number of other equations in the system. This paper is going to find out most of the variables in that system and analyze their position and effect on the wider economy.
Secondly, the paper is focusing on one of the strongest and the most well managed economies of the world; United Kingdom. Analysis of this economy will not only be useful for the policy makers of the United Kingdom themselves, but also those of the other countries seeking to find an optimal point of use of monetary policy in regards to the effect it has on the other important variables in the country.
Finally, this research paper is important because it is going to present a snapshot of the United Kingdom and a primary, empirical analysis is being done in this paper to reach a conclusion as to what is the effect of the monetary policy on the rates of unemployment in the economy and especially in the United Kingdom. Through the data provided to the public by the office of national statistics, the regression analysis between the variables described later in the paper makes this paper significant both in theory and as an instrument for application.
1.3 Research Questions
It has been noted that the research question in a research paper actually provide dimension and boundary to the analysis of the research paper and makes sure that the information that it presents does not become irrelevant
.
After roughly going through the literature present on the topic consideration, the following research questions have been crafted out to provide analysis on.
i) What are the functions of the monetary policy in an economy and how important is its role in the stability and growth of the economy?
ii) What is the significance of monetary policy in the United Kingdom?
iii) What is the trend and situation of unemployment in the United Kingdom?
iv) In theory, what is the relationship between unemployment and monetary policy and what other variables are involved in the process?
v) What is the relationship between unemployment and monetary policy in the United Kingdom and what other variables are involved in the process that is found to exist?
Chapter Two: Literature Review
This section of the paper is going to present the secondary findings of the data collected. Secondary data is considered to important because it not only helps the research gather more ideas and information about the topic under consideration but also enables him or her to avoid any duplication of a previously done study. The strategy for the creation of this literature review section will be to first present theory on the matter of unemployment to reflect the enormity of the issue that it is for the economies of today. Next, this section is going to present theory on the matter of monetary policy, its constituents, its supporters and its base theory, the limitations of its use and, the disadvantages of its use. The step of the literature review is going to be to present the theories and researches on the alleged relationship between monetary theory and unemployment rate in the country. This part of the section will be further divided into two parts with the first part focusing on the general monetary policy and unemployment relationship and the second focusing on the same but from the perspective of the United Kingdom, since the scope of this paper is limited to United Kingdom.
It is however important to mention here before the actual review begins, that this section is only going to present the theory and the academic researches. The analysis of them is going to be done in the data analysis section of the paper along with the results of the primary findings.
2.1 Unemployment
To start with, Layard et al (1991) notes an interesting fact in regards to the rate of unemployment existing in a country. They say,
"The long run equilibrium level of unemployment is affected, first, by any variable which influences the ease with which unemployed individuals can be matched to available job vacancies and, second, by any variable which tends to raise wages in a direct fashion despite excess supply in the labor market."
Layard et al (1991) further take this point to study the various factors that fall into these two categories that affect unemployment equilibrium in the long run. It has been studied that the variables forming the part of the first variable fall actually on the unemployment/vacancy locus or better known as the Beveridge Curve and therefore can be seen to have a direct effect on the rate of unemployment prevailing in the country. The second set of variables on the other hand does not depict an explicit impact on the rate of unemployment and do so in an indirect manner. For studying the impact on the unemployment rate, the shift or the movement of the Bevridge curve, as pointed out by Layard et al (1991) is a sufficient but not a necessary condition.
The factors included in the direct variables affecting unemployment are as following.
The first one is the unemployment benefit system which seriously influences the keenness of the unemployed masses to try out for jobs and therefore fill vacancies. In the system then, the important aspects are i) the level of benefits, ii) the coverage of the benefits, iii) the length of time for which the benefit is made available to an individual and finally, the strictness in the implementation of the system.
Secondly, the rise in the real interest rate of a country also promotes the level of unemployment by actually raising the returns on non human wealth.
Thirdly, the employment protection laws tend to make the business organization more cautious about filling vacancies, thus resulting in a slowing down of the speed at which the unemployed move in work. In regards to this, Layard et al (1991) say that,
"However, the mechanism here is not clear cut. For example, the introduction of employment protection laws often leads to an increased professionalization of the personnel function within firms, as was the case in Britain in the 1970s."
And finally, the factor shifting the Beveridge Curve is the barriers to geographical or occupational mobility.
On the other hand, the factors which have direct impact on wages are the levels of union power in wage bargain, union coverage in the industry or in the labor market, the level of coordination of wage bargains and the degree of competition in the product market. Next, the real wage resistance, labor taxes and change in trend productivity growth happen to affect the rate of unemployment is an economy (Layard et al 1991).
This above however studied however focused upon some of the factors that shift the rate of unemployment from a sociological or politically influenced perspective. Before moving forward, it is important to define the stock of unemployment in an economy. Knight (1987) says that,
"From a theoretical point of view, the stock of unemployment in an economy at a particular moment in time is most easily defined as Ut = Lt - Et where,
Ut is the number unemployed
Lt is the total labor force
Et is the number of people employed"
Manipulating the above equation, the percentage of people unemployed in an economy can be written as Ut/ Lt = (1 - Et/ Lt) * 100 = Ut
Furthermore, Knight (1987) focuses on the point that greater the stock of unemployment in an economy, the greater the resulting underutilization of labor in the economy. The calculation of the extent to which the resources of an economy are underutilized is one of the most important considerations in for the overall management of an economy (Knight, 1987). The labor force of an economy is made up of the people, willing and able to work. Similarly, those unemployed have also been divided into various categories depending on how and why they are unemployed. These categories are made up of i) frictionally unemployed, ii) discouraged workers, iii) those not able to work.
Pissarides (2000) studies the trade in the labor market and studies that the central idea of the model that he represents is that the trade in the labor market is a decentralized economic activity. This explanation of trade being a decentralized or non trivial economic activity is because heterogeneities, frictions and information imperfections exist in the market and thus, to capture the idea of creation of jobs, both the producers and buyers of jobs face un coordination, time consumption and cost. Pissarides (2000) says that the labor market movements can be explained like various other aggregate functions and that the usefulness of the matching function that has been created depends on the empirical viability of the success of capturing the salient features of exchange in the labor market.
However, Pedersen (1985) considers the worth of the market clearing model of labor itself and questions whether the fluctuations in the rate of unemployment can actually be explained by the model. The model focused upon by Pedersen (1985) is the competitive supply and demand model of equilibrium of labor market and says that both the factors depend on the real wage and technological coefficients. It has been noted that,
"if there is complete certainty about prices and wages, changes in the aggregate demand cannot have an effect on unemployment. Prices should clear the output market and real wages should not be affected by demand. Supply shocks, like changes in raw material prices or general productivity changes, may have some effect on unemployment but only if they are expected to be temporary. Supply shocks require a change in the market clearing wage since they shift the demand curve for labor. A permanent shock shifts the demand curve permanently and requires a permanent change in the real wage."
About the enormity of the problem that unemployment actually is especially for the policy makers and those politician depending upon the reliability of those policy makers, Worswick (1991) notes that among the various factors that brought down the shift from the Conservative to the Labour during the second world war, persistent unemployment of the interwar years (rarely less than 10 percent and rising up to 20 percent in the early 1930s) was one of the most significant reasons.
Fineman (1987) then gives a turn to the direction of attention and studies the unemployed rather than the phenomenon of unemployment itself. Even though the focus of this paper is majorly on the phenomenon of unemployment, it is considered useful to mention briefly how the people affected by this play the game and why. These considerations by the author regard the problems that people face when they seek meaning out of their lives, the level of functioning of the government agencies, the social tensions that exist and the effect that unemployment has on the social, economic and personal life of both the employed and the unemployed.
2.2 Monetary Policy
As far as scientific base for the monetary policy is concerned, the credit goes to the monetary theory (Bofinger, Reischle and Schachter, 2001) and focuses upon the policies that the policy makers should pursue for their daily work as well as for the design of new institutional solutions.
Before however, monetary theory and monetary policy are discussed any further, it is important to define what money in terms of economics actually is so really understand what underpinnings the change in the monetary policy on an economy really holds. Bofinger, Reischle and Schachter (2001) first study the microeconomic approach of the definition of the money and say that down to the basics, it is the currency in circulation which people can use as a store of value, a medium of exchange and a unit of measurement.
Now when the word money is said, paper bills come into the mind of a person or probably a bunch of gold coins. However as has been noted, anything that fulfils the functions of the money can be used as a perfect substitute for currency (C). The biggest example especially from the perspective of the commercial banks, reserves that are held by these banks hold with the central bank (R). The total of reserves and currency makes up the monetary base (B) (Bofinger, Reischle and Schachter, 2001). As the authors note it, there are many economists who actually consider the monetary base of an economy to be the most relevant and thus useful concept of money because of its exogenous nature.
Secondly, in the perspective of the private non banks, a close substitute of money in circulation is the sight deposits (D), or the currency that is achieved in hand with very low or negligible cost of transaction. The addition of the currency in circulation and the sight deposits that makes up the second most important concept of money, M1.
"In monetary policy the money stock M1 is regarded as an important indicator, but most central banks look also at more broadly defined aggregates, which are labeled M2, M3 or even M4. The European Central Bank uses a reference value for the money stock M3 as a pillar of its stability oriented monetary policy. The ECB defines these broader aggregates as follows:
M2= M1 + deposits with agreed maturity of up to 2 years + deposits redeemable at notice up to three months.
M3= M2 + repurchase agreements + money market fund shares/unites and money market paper + debt securities issued with maturity up to 2 years."
Mankiw (1997) studies that the goals of monetary policy of keeping the inflation rate in the economy low and thus the prices stable and further to keep the gap between the actual and the real Gross Domestic Product as small as possible are widely agreed and can be achieved by limiting the rate of growth of M2 and M3 (the broader money aggregates over a long enough period of time. Furthermore, Mankiw (1997) also notes the different approaches to the monetary policy and says that the important variables in dealing with the supply of money in the economy are the monetary aggregates themselves, interest rates and the exchange rate. The first as is noted is the judgmental eclecticism and deals with the control of the volume of bank reserves by open market sales of treasury securities. "In recent years, the volume of such sales has been adjusted to target the value of the federal funds interest rate. Thus, for the time intervals up to several weeks, any disturbance in the statistical relation between the federal funds rate and bank reserves (that is, in the banking system's bi variate demand function for reserves) induces the Federal Reserve to alter reserves in order to maintain the desired level of Federal Funds rate."
As far as matching the growth of the money supply in the economy with the growth in other economic factors such as population, GDP and business operations, it has been noted that Milton Friedman's proposal for the monetary policy was a constant growth of money supply in the economy (Mankiw, 1997). "Setting the constant growth rate of money equal to the expected growth of potential GDP minus the expected rate of increase of velocity implies a zero expected rate of inflation."
The third alternative for managing the monetary policy as proposed by McCallum (1988) and Taylor (1985) proposes and optimal rule for using the monetary policy to target nominal GDP and a simple partial adjustment rule that approximates the effect of the optimal rule. The usefulness of this monetary targeting rule is found in the more satisfactory economic performance (measured through the rate of inflation and stability of nominal GDP growth) than achieved through both eclectic judgmentalism and passive policy of constant M2 growth.
Mishkins (2007) studies that over the past three decades, there has been an extraordinary transformation in the use and behavior of monetary policy and the answer is provided through the ideas of i) the long run tradeoff between the level of employment and inflation, ii) the expectations that are critical to monetary outcomes, iii) high costs of inflation to the overall economy, iv) the subjugation of the monetary policy to the problem of time inconsistency, v) the level of independence of the central bank and finally vi) the a strong nominal anchor being key to producing good monetary policy outcomes.
A number of long term relationships have been found to exist through research between the money supply in the economy and other economic factors (Walsh, 2003). Firstly it has been found that correlation exists between inflation and the growth rate of money supply is almost 1 (varying between 0.92 and 0.96, depending on the definition of the money aggregate used by the central bank) meaning that a rise in the money supply would almost definitely raise inflation in the economy. In regards to the topic of this paper, Walsh (2003) notes an interesting thing and study that through empirical evidence, there has found to exist no relationship between money supply and real output. "Thus, there are countries with low output growth and low money growth and inflation, and countries with low output growth and high money growth and inflation and countries with every other combination as well."
Artus, Barroux and Applied Econometrics Association (1990) study that when pursuing a monetary policy that governments and the central banks focus on a number of variables. The variable that the government and the central banks seek to stabilize are known as the targets. Their midterm equilibrium values that is, the trend path values are also often called targets. It has been noted however, that these targets should definitely be selected and are the growth rate of gross domestic product, the rate inflation and the level of exchange rate. A number of tradeoffs with respect to these targets are the following. "A) inflation increase if the growth rate of Gross Domestic Product increases, the level of the exchange rate held constant, b) the level of the exchange rate decrease when the rate of inflation increase the growth rate held constant and C) the level of the exchange rate increases when the growth rate of GDP increase, the rate of inflation held constant. As a matter of fact, there exist only two independent targets (e.g. the growth rate of Gross Domestic Product and the level of the exchange rate."
However, Solow and Taylor (1999) note that merely projecting the point that monetary policy influences inflation and real economic outcomes means that a person is actually ignoring the problem of two way interaction between the monetary policy and economic behavior and thus, one of the core reasons as to why the issue of management of the monetary policy and thus the money supply in the economy is under constant evolution is because difficulty still faces the policy makers and the no way guarantees economic performance and growth in the long run. As Gali (2008) says then, the area of monetary economics has been among the most fruitful research areas within macroeconomic and the researchers to understand the relationship between monetary policy, inflation and the business cycle has led to the development of a framework known to be the new Keynesian model which is currently in application for the management of the monetary policy.
Cencini and Baranzini (1996) say that if the market mechanism work perfectly and with full information in the society, there would be no undesired unemployment. The point of this being that it is actually the lack of information between the various players of the economy that gives rise to the issue of unemployment. As far as interest rate is concerned, it has been noted that interest rates actually have a deflationary effect on the economy. They reduce the incentive that the organization has for producing and thus, unless a process of over accumulation of capital is achieved, it is impossible to avoid unemployment in the economy. "In order words, the equality between total supply and total demand is compatible with any level of production and therefore, also with any level of employment."
Furthermore as Sloman (2004) points out, in a simple Keynesian model, GDP is assumed at its maximum levels and thus, it is one of the basic assumptions of the full employment model that the economy is operating at the natural rate of unemployment. The deviations from this are described by Keynes as the inflationary and deflationary models. In the inflationary models, the inflation rate goes up and the GDP actually increases the full employment GDP meaning that the economy is actually working beyond its capability. On the other hand, in a deflationary gap, the economy is actually behind the full employment GDP meaning that some of the resources of the economy are underutilized and thus not properly managed.
The followers of the school Rational Expectations or the new classical school of thought considers actually that there exists no tradeoff between the unemployment rates and the inflation rates in an economy. These arguments that they make are based in the following two assumptions:
i) Prices and wage rates are flexible and thus markets clear very rapidly. This means that there will be no disequilibrium unemployment, even in the short run. All unemployment will be equilibrium unemployment or voluntary unemployment.
ii) Expectations are rational but are based on imperfect information for the external sources.
The new classical believers argue that the past trends are of no use to the economy for analysis and policy recommendations and therefore, they base their analysis on the current state of economy and the current information about the current policies that the people have. People looking at a variety of this information and then using their own sense and strength of reasoning, assess the future on the basis of the information available to them. However, these predictions and the judgments of the economy based on them can very often go wrong.
"If the government raises aggregate demand in an attempt to reduce the rate of unemployment, people will anticipate that this will lead to higher prices and wages, and that there will be no effect on the output and unemployment. If their expectations of higher inflation are correct this will thus fully absorb the increase in nominal aggregate demand such that there will have been no increase in the real demand at all. Firms will not produce anymore output or employ any more people...Output and employment will only rise therefore if people make error in their predictions."(Sloman, 2004)
Dransfield and Dransfield (2003) note Friedman to say that money supply altered in the short run has a destabilizing effect on the economy. "if the central bank increases the money supply during a depression, thus will take time to have an effect on economic activity and prices."
It has further been noted by the authors that there is a particular rate of unemployment known as the natural rate of unemployment which is actually consistent with the rates of inflation prevailing in the economy and that any deviation from that rate of inflation will actually disturb the stability of the inflation trend in the economy. "If the government tries to buy the rate of unemployment by increasing inflation, this will only lead to increasing levels of inflation, which will eventually become unsustainable."
According to Friedman (Dransfield and Dransfield, 2003), people are more concerned, about the real wage than the nominal wage and thus they are concerned about wage negotiation. Furthermore according to the Phillips curve, there is a tradeoff between the unemployment rate and the inflation rate in an economy.
Carlberg (2009) notes that interaction between the European central bank and the government and says that an increase in the European money supply would end up lowering the rate of unemployment in the region. On the other hand however it would give rise to inflation. Government purchases on the other hand lower the rate of unemployment in the region and hand in hand raise the rate of inflation. The effect between the two is actually completely balanced with 1 percentage rise and fall in each. Calberg (2009) further notes that that the target of the European Central banks is usually to pursue zero inflation in the economy and that the instrument that they use for this purpose is the money supply and if the target that the European governments are pursuing is zero unemployment rates in the region, then the instrument that the government departments would chose would be government purchases. Both of them have the same and equal effect on the rates of inflation and the unemployment and by dividing this responsibility of managing unemployment and inflation rates, the two institutes actually check a check on the other and a balance of their performance and strategies. These organizations then fall into a number of cooperative strategies with the final aim of providing the maximum welfare to the public and making the economy as stable as possible.
Chapter Three: Research Methodology
3.1 Research Design
There is no denying the fact that the method with which a research is carried out has a very significant influence on the quality of the resulting research paper, the results of the research itself in terms of their orientation, analysis and quality. Keeping that into account, the research methodology for this paper has been carefully designed and structured so as to achieve the best possible analysis for the topic under consideration.
The research paper followed a combination of secondary and primary data collection techniques to reach the conclusion and a sound analysis from both dimensions. This allowed the researcher to look into the problem of monetary policy and its effects on the unemployment rates through i) the expert opinion presented in the literature available on the areas and ii) the statistical relationship found between the two variables. Following this method for conduction of research, the two types of findings supported each other and overall the research proved to be a sound one.
The following sections are going to shed light on the details of research methodology of this paper, the resulting and expected reliability and credibility of the paper and the limitations faced during the conduction of the paper and how the paper is limited in explaining what it is aiming of finding out.
3.2 Primary Data Collection Method
The primary data collection was gathered with the aim of statistically linking the variable of monetary policy with the variable of unemployment. The point for this was to put the data in the form of a mathematical equation and analyze with respect to econometrics considerations the level of strength of the relationship between the monetary policy and unemployment. Since the focus of this paper in on these macroeconomic variable but with regard to United Kingdom, the data collected will obviously be from United Kingdom as well. The source of this information is simply and the provision is the courtesy of United Kingdom's Government. The website of National Office for Statistics of United Kingdom is the source from where all the information required for unemployment and variable of monetary policy have been taken. For the purpose of monetary policy, the Federal Bank of United Kingdom's website has also been referred too.
3.2.1 Analysis through the Primary Data
After getting the primary data was collected through the official records, the next step was to put the data in a form such that the relation between the two variables could be seen. The following steps were followed.
3.2.1a General form of the Equation
Y = o + 1X1 + 2W2 + 3W3 + e
X1 = o + 1W2 + e2
Where,
Y: is the change in the rate of unemployment in the United Kingdom for the period 2000 to 2010 as made available by the National Office for Statistics
o: is the constant term measuring the natural rate of unemployment existing in the United Kingdom for the period 2000 to 2010 (which is basically unaffected by monetary policy or any other macroeconomic variable).
o: is the constant term for the second equation taking into account the factors other than the incorporated variables in the equation.
X-1: is the change in the monetary supply in the United Kingdom made available in the country from the period 2000 to 2010 by the Federal Bank of United Kingdom.
The bank of England manages the M4 monetary aggregate depicting the picture of an actually complex financial and economic system in the country. As Gilbody (1988) defines it, M4 monetary aggregate comprises of the M3 (which consists of M1 plus PS sterling time deposits in banks, plus PS holdings of sterling bank Cash Deposits) plus PS holding of building society shares and deposits and sterling Cash Deposits, and bank Cash Deposits. The United Kingdom has another monetary aggregate M5 (comprising of M4 plus PS non building society holdings of money market instruments, bank bills, treasury bills, local authority deposits, certificates of tax deposits, and national saving instruments, excluding certificates "save as your earn" and other long term deposits), the Bank of England makes use of M4 aggregate to manage the supply of money in the economy. As Mullineux (2996) notes, one of the biggest short comings of a simple sum monetary aggregate is its inability to adjust in response to financial innovation, implying basically that, it is relatively more stable than the smaller monetary aggregates.
W2: Is the change in the rate of inflation in the economy of the United Kingdom for a period of 2000 to 2010. The rates of inflation have been measured by the retail price index instead of the consumer price index. The reason being the as far as the general public in concerned, the retail prices of every day products makes the biggest difference.
W3: measure the change in the rate of bank interest rates prevailing in the economy. These have been taken from the website of Bank of England.
e: stochastic error term or the residual amount, checking the level of unemployment in the country not explained by the monetary policy.
A very high error term would mean that the explained sum of squares is low and that the overall relationship between the two variables is weak. This could because of some other variable missing from the equation which helps explain the movement rates of unemployment (for example the level of gross domestic product for the year) or because the type of equation is not correct (for example, the change in monetary policy causing a change in the rate of unemployment may have a strong relationship). If the error term for the equation turns out to be very high, the form of equation will be changed to double log equation and then the results will be checked. If in both the equations the result turns out to be a high error term and a lower 1, the conclusion will be that the monetary policy does not affect unemployment rates in the United Kingdom to a very large extent.
3.2.1b Hypothesis
The following is the expectation for the nature of relationship between the monetary policy determinants of unemployment in the United Kingdom.
i) First set
a. Null Hypothesis: Ho: 1, 2, 3, 4 = 0
b. Alternative Hypothesis: H1: 1, 2, 3, 4 0
ii) Second Set
a. Null Hypothesis: Ho: 1 = o
b. Alternative Hypothesis: H1: 0
For these relationship, = 0.05 meaning that 95% of the times, the relationship that monetary policy significantly affects unemployment should be true for us to consider that such a relationship really exists and is not a random occurrence.
3.2.1c Decision Rule
Reject H1 if 1 is not significantly different than zero at a 95% confidence level and reject Ho if 1 is significantly different than zero at a 95% confidence level meaning that significant relationship exists between the monetary policy and unemployment levels in the United Kingdom.
3.2.1d Expected Results
Through the study of the literature, it is expected that that unemployment rate will have a negative relationship with the decrease in inflation. As the inflation goes up, unemployment goes down. The reason for this expectation is the link that money supply has with the two variables. As the money supply in the economy goes up, new jobs are created through the money invested and the rate of unemployment goes down. On the other hand, as the money supply in the economy goes up, there is more money available for the same basket of goods in the economy. Too much money then ends up chasing too few goods in the economy thus resulting in the rise in the prices of each good. So basically, as mentioned earlier as well, policy makers face a tradeoff between unemployment and inflation rates in the economy. To further make matters for the policy makers interesting, both inflation and unemployment have recurring implication for the economy and this then make it necessary for the policymakers to strike a balance between the two and constantly keep on managing the two variables.
Next it is expected that unemployment will have a negative relationship with the level of money supply in the economy.
Thirdly, with the unemployment rates, the bank interest rates are expected to have a negative relationship. The reason for expecting is the relationship between inflation and exchange rates. According to Fisher, interest rates in an economy at any time are actually the sum between the inflation rate and the real exchange rate (Mankiw, 2005). Therefore, it seems reasonable to expect that if inflation rate and unemployment are negatively related and that inflation rate is actually a strong component of the interest rates, there will exist, a negative relationship between unemployment and interest rates in the economy.
Whether the expectation comes out to be true or not has been analyzed in the data analysis section of the paper.
3.3 Secondary Data Collection
Apart from the primary data that is collected, secondary data for any research paper forms a very important part if one is to seriously see what others have found about the topic. Not only does this allow the researcher to have more ideas about the topic, but it also helps him or her to avoid repeating the same research and getting the same results again. The point of researching, that something should be input into the academic world needs to remain intact.
Keeping that in mind, this research paper gathered a significant amount of academic literature focusing on the alleged relationship between the monetary policy and unemployment rates in a country. This literature was taken for various sources which will be discussed later in the section and have been provided in the paper under the heading of literature review. The material and the information gathered will be later used in the paper to analyze the primary finding under the light of the secondary ones so that the overall conclusion reached is sound and covers the idea of monetary policy affecting the unemployment rates from all sides.
3.3.1 Source of Secondary Data
The secondary data was collected through online books and journals. Books were mainly studied for the study of theories and models (if any) were present on the topic and journals were studied to see whether others have found this topic of relationship between monetary policy and unemployment rates intriguing enough to have researched upon it. If yes, the findings will be studied and presented and used for analysis.
3.4 Ethical Issues taken Into Account
Since the study is based on the macroeconomic variables and concerns the entire public of the United Kingdom, no such ethical issues were met. The issue raised is one that requires official attention and therefore, official data has been sought. In that, no ethical consideration needed to be taken because no psychological or physical harm or social harm for that matter was being inflicted upon an individual or a group.
3.5 Reliability Credibility and Generalizability of the Research Paper
When a research paper is being created, its reliability happens to be a major concern. The simple reason being that the paper presents the theory upon which, a number of practical applications can later be based. The question of reliability actually asks whether the approach of the paper and the policy recommendations proposed by it can actually be incorporated into the real life. Since this paper is researching upon the macroeconomic policy implications, the argument of reliability becomes seriously important. Taking that into consideration the reliability of the results of this paper was given careful thought. The results of this paper are reliable because the data is taken from the most reliable and efficient data collection sources, the office for national statistics. This organization regularly and carefully updates its data in regards to the society, economy and politics of the United Kingdom and thus provides its users with up to date and most reliable information along with an effective snapshot of the situation in which the United Kingdom is in. Next, the paper presents reliable results because all the findings have been processed through MINITAB, one of the most reliable statistical software as far as the results are concerned. The data was not differenced or transformed in any way to avoid the loss of originality and therefore, again the findings are more close to actuality of the situation in the United Kingdom with respect to the monetary policy than presented by the papers which have transformed their date to achieve simpler results.
Next, is the question of the credibility of information that this paper presents. All the information taken from different sources have been cited and thus no part of the data actually became victim to the guesses and estimates of the researcher. The credibility of this paper is also reinforced by the fact that it absorbs information and analysis from both the primary and the secondary sources. The overall view presented then, is actually a convergence of the two dimensions. This makes the paper strong in its argument and more elaborative of its topic.
Finally, the information and analysis presented here is generalizable to not only the economies like that of the United Kingdom but also to the developing and under developed countries. The relationship that is focused upon through this paper actually a problem under consideration in many countries in the world. The tradeoff between inflation and unemployment makes the choice of policy application for the policy makers actually tough. This paper then, touches this problem and does that in an efficient manner. The findings of this paper then, can be applied to or at least provide aid to a number of other economic concerns of the world, thus being relatively high in the generalizable information category of research papers. Also, this paper has been made with the aim of making it generalizable and not specific. Even though the focus is on the economy of the United Kingdom solely, comparisons will be provided in the data analysis portion and also, the recommendations will be made as generalizable and usable as possible.
3.5 Limitations of the Research paper
The biggest limitation of this research paper is the lack of data and the difficulty of finding data in tabularized format and in the form that is required. Especially with finding the money supply value for the paper (which was one of the main and the most important elements of the research paper), finding the data was actually a tough. The data could have only been received from the Bank of England and the website only quoted the change in the money supply and not the absolute values themselves. Finally then, the change in the money supply value for the ten years had to be used which actually changes the actual course of the research. This limitation is then expected to have an effect on the efficiency of the equations that have been formed.
Moreover, this paper is limited in the analysis for the number of variables that have been included in the analysis. This is because the model that was being created was tried to be kept simple in its analysis and procedure so as to be reader friendly yet informative. Finally, the research paper is drawing analysis of the topic from the data of the economy of United Kingdom and therefore, the results may or may not be exactly applicable to the other economies. As has been pointed out, the recommendations will be applicable to a number of economies. That said, the analysis of the United Kingdom's data can actually present a number of interesting findings to other economy's policy makers as well and they can actually have the information and results of the various policies and ideas of different real life scenarios. Nonetheless, through this paper the analysis of the effect of monetary policy on the rates of unemployment in the economy, taking into consideration the rates of inflation and interest in the economy is actually quite sound.
Chapter Four: Data Analysis
This section of the paper is going to present the findings of the data that has been collected through the methodology mentioned in the section above. The regression analysis was done through the statistical software MINITAB. A number of variables and relationships were hypothesized. This section is going to present both the tabular data and the discussion of it.
Regression Analysis: Unemployment versus change in RPI, Bank Interest, m4
The regression equation is
Unemployment = 7.55 + 0.0881 chnge in RPI - 0.491 Bank Interest rates
+ 0.0266 m4
Predictor Coef SE Coef T P
Constant 7.5497 0.1291 58.46 0.000
chnge in RPI 0.08813 0.06228 1.41 0.160
Bank Interest rates -0.49127 0.02921 -16.82 0.000
m4 0.02658 0.05763 0.46 0.645
S = 0.571131 R-Sq = 70.3% R-Sq(adj) = 69.6%
Through the equation above, the following econometrical conclusion can be derived.
i) All else being equal, 1 unit rise in the level of inflation in an economy leads to a 0.0881 percent rise in the level of unemployment.
ii) All else being equal, 1 unit change in the level of bank interest rates causes a 0.491 percent decline in the levels of unemployment in the country.
iii) 1 unit (billion pounds) change in the level of money supply in the economy, the rate of unemployment will rise by 0.0266 percent.
Before coming to the analysis, the following is the analysis of variance table for the data of the economy
Source DF SS MS F P
Regression 3 112.696 37.565 53.57 0.000
Residual Error 128 89.760 0.701
Total 131 202.455
The R square for the regression analysis is 70.3% percent meaning that the three variables taken into account actually explain 70.3 % of the variations occurring in the change in the rate of unemployment.
The first conclusion is actually surprising and against the expectation made about the economy after having reviewed the literature. The relationship between inflation and the changes in the unemployment is actually coming out to be positive meaning that as the rate of inflation in the economy rises, the level of unemployment also rises. It is important to mention here that this is true strictly for the data of the United Kingdom and that for other economies of the world, this may or may not be true. This is actually bad news for the economy and sounds a lot like the great depression where the biggest surprise for the policy makers was the unemployment and inflation was rising together. With the rise in inflation, it actually meant that the economy is growing however, with the rise in unemployment, it was becoming apparent that this is not true since the business that once provide employment to people are shutting down thus resulting in an increase in the level of unemployment. The management of this became an important and well recognized and much feared trouble for the economic policy makers of the world. Finding the economy of the United Kingdom in the same state then is actually worrisome and the point that the economy has actually been in the state of decline since the 2000 (roughly). Before coming to that conclusion however, the following graph is going to present the trend of the change in unemployment in the country.
This graph shows that the trend of unemployment in the country has been rather fluctuating. In the first four years from 2000 to 2004, the rate of unemployment is actually seen to decline gradually. Let us see the trend for the rate of inflation in the country as well before going further with the analysis.
Simply looking at the trend then, it is seen that the rate of inflation as measure by the retail price index in the country is actually rising throughout the period of 4 years. Even in the first four years, it is seen to rise with almost uniform acceleration. In this time then, the rate of unemployment can be seen to decline depicting thus a negative relationship between the two variables. However, the trend is seen to change after 2008 when both the unemployment and retail price index are rising. This however occurs after a dip that both take. Unemployment declines sharply in the year 2008 RPI also takes a very strong decline in the year 2009. After that the unemployment rate literally rises sky high reaching to new boundaries whereas the inflation rate goes back to its normal uniform acceleration.
This means then that that inflation rate is actually depicting good news for the economy by depicting that the economy of the United Kingdom is actually growing with stable rate. The problem that can be seen to exist in the country is the trend and the management of employment. The trend and the rates of unemployment in the country are following trends that have previously been observed during the recession of the 1980s and the 1930s. Nobody wants to go back there and thus it has become extremely essential for the policy makers to manage the trend of unemployment.