SOM 306 CASE ANALYSIS FORECASTING AT A BANK OF EUREKA October, 19th 2011 Prof.

Gordon Johnson

SOM 306 CASE: 50 POINTS FORECASTING AT BANK OF EUREKA

James Dow and Gordon Johnson

You work at the Bank of Eureka to help customers, including retired people, to plan for the future. Often the value of pensions does not keep up with inflation. Hence retired people need a forecast of inflation. One of the assertions is that changes in Federal Reserve policy can affect inflation. You are given data on money and inflation. Money = average annual growth over 5 year periods, and inflation is average annual rate of inflation over 5 year periods. Period Ending 1965 1970 1975 1980 1985 1990 1995 2000 2005 Money 9 7.9 11.5 12 11 7 2.8 7.1 10.1 Inflation 1.6 4.2 8 10.5 7 4.9 3.8 3 2.7

Do the data support a connection between the rate of increase in the money supply and inflation? Using the data on the growth rate of Money and inflation, run a regression of the rate of inflation on the rate of growth of the money supply. Use Excel Data Analysis. (1) Interpret slope (What does the coefficient on the money supply variable tell you)? (2) Forecast inflation if money = 8 (3) What is the meaning of the p-value? Is the regression coefficient significant? (4) Interpret the coefficient of determination (5) Is faster money growth always associated with higher inflation?

Case will have 2 scores: content, writing (grammar). Case report is team project (minimum 4 students per team). One person on team should know Excel applications in statistics. Maximum 2 pages double spaced. ----------------------------------------------------------------------------------------------------------------------------

Money Supply 9 7.9 11.5 12 11 7 2.8 7.1 10.1

Inflation 1.6 4.2 8 10.5 7 4.9 3.8 3 2.7

Year 1965 1970 1975 1980 1985 1990 1995 2000 2005

Regression Statistics Multiple R R Square Adjusted R Square Standard Error Observations 0.570874504 0.325897699 0.22959737 2.523663159 9 Coefficients Intercept X Variable 1 0.13586408 3 0.56731152 1 Standard Error 2.815017211 0.308386133 t Stat 0.04826403 3 1.83961423 8 P-value 0.962854001 0.10840628

Forecasting Analysis

We have prepared an analysis for the Bank of Eureka in order to see if the given data support a connection between the rate of increase in the money supply and inflation. Our groups decision is based on the following analysis: interpretation of the slope and p-value, forecasting inflation, and explaining the coefficient of determination. We begin the study with running a regression of the rate of inflation on the rate of growth of money supply shown in the date above. Based on the Excel output shown above we now can interpret the slope. The formula for the slope is Y = MX + B. The coefficient of money supply variable is represented by X which tells us that Now that we have the formula it is easy to forecast inflation if money equals 8. By plugging in appropriate numbers in the formula we get the answer of Y = 0.567311521(8) +0.135864083 = 4.7 After that we will go ahead and explain the meaning of the p-value. A p-value is a measure of how much evidence we have against the null hypothesis. The null hypothesis, traditionally represented by the symbol H0, represents the hypothesis of no change or effect. The smaller the p-value, the more evidence we have against H0. It is also a measure of how likely we are going to get a certain sample result or a result more extreme, assuming H0 is true. Since alpha is 0.05 and our p-value on the x variable is 0.10840628, then p-value in our case is greater than alpha, which means that we do not reject the null hypothesis. The p-value in this case equals 0.10840628, which means this result is statistically insignificant. This is due to the fact that the lower the significance level, the stronger the evidence required. We should also remember that the size of the p-value for a coefficient says nothing about the size of the effect that variable is having on your dependent variable. It is possible to have a highly significant result (very small P-value) for a miniscule effect. Next, we look at the coefficient of determination which is 0.32 in our case. The coefficient of determination is the estimate prediction. This essentially shows how well the model explains and predicts the future outcome. Since R-square equals 0.32, it tells us that the estimates poorly

explain and predict the future outcome of inflation and money supply. It can be represented as being 32% reliable. Finally, we can say that faster money growth is not always associated with higher inflation. From 1995 to 2005, there was a rise in money supply, but inflation was going down. Money is not the only reason there is inflation. There are many causes for inflation, depending on a number of factors. For example, the other common causes of inflation are a rise in production costs, which leads to an increase in the price of the final product. This can be caused by raw materials increasing in price or a rise in labor costs. Another thing to factor in this equation would be a shift in supply and demand. Inflation basically can be caused by international lending and national debts. As nations borrow money, they deal with interests, which in the end cause prices to rise as a way of coping with their debts. Zimbabwe for example, is printing intensely to pay debts, thus leading to inflation. A deep drop of the exchange rate is another factor which also can contribute to inflation. Therefore, we can tell that the given data doesnt support a connection between the rate of increase in the money supply and inflation.