Dickey-Fuller Theory Essay

CHAPTER THREE

THEORETICAL FRAMEWORK AND METHODOLOGY

3.1 Theoretical frame work

The basic theoretical frame works are the monetarists’ theory of Inflation, and structural rigidity theory of inflation.

Monetarists’ theory of Inflation

The monetarists emphasise the role of money as the principal cause of demand pull inflation. They contend that inflation is always a monetary phenomenon. They used a simple quantity theory of money, by employing familiar identity of Fisher’s Equation of exchange: MV=PQ

Where M is the money supply, V is the velocity of money, P is the price level, and Q is the level of real output.

Assuming V and Q as constant, the price level (P) varies proportionately with the supply of money (M). With flexible wages, the economy

(Jennings et al. 1999).

3.7 Unit Root Test Macroeconomic time series data are generally characterized by stochastic trend which can be removed by differencing. Thus, the study will use or adopt Augmented Dickey-Fuller (ADF) (1979) techniques to test and verify the unit root property of the series and stationery of the model. If the unit root tests find that a series contain one unit root, the appropriate route in this case is to transform the data by differencing the variables prior to their inclusion in the regression model, but this incurs a loss of important long-run information.

Alternatively, if the variables are co-integrated, that is, if a long-run relationship exists among the set of variables that share similar non-stationary properties, regression involving the levels of the variables can proceed without generating spurious

The F-statistics is used to reject or accept the null hypothesis, no causation between the variables when F-statistics is greater than 2 and less than 2 respectively. Granger causality theorem suggests that there will be granger causality in at least one direction if there exists co-integration relationship among the variables provided the variables are integrated order of one (Muhammad et al. 2008). According to Engle-Granger (1987) argued that granger causality test is conducted at first difference through vector auto regression (VAR) method than it will be misleading in the presence of co-integration. An additional variable to ARDL method such as the error correction term will helps the study to capture the long run relationship. Therefore, Granger causality test involves the error-correction term which is in variant PTH order. The example is given