Examine Quantity Theory of Money
Structural Change by 1973 Oil Crisis
Part A
 Examining the Quantity Theory of Money
Part B
 Test Whether 1973 Oil Crisis cause a structural change
About Quantity Theory of Money
 The Quantity Theory was first developed by Irving Fisher in the
inter-war years as is a basic theoretical explanation for the link
between money and the general price level.
 Roughly speaking, the Quantity Theory try to explain the cause of
inflation.
 The Theory is argue that the inflation is caused by the growth of
Money Supply
Cause of inflation
1)
The Quantity Theory
2)
Neo-Keynesian

Cost push inflation

Demand pull inflation

Built-in inflation
Methodology
 Fisher identity or equation of exchange
MV = PY
 M is the money supply
 V is the velocity of circulation of money
 P is the general price level
 Y is the real value of national output (i.e. real GDP)
 Fisher identity or equation of exchange
MV = PY
lnM + lnV = lnP + lnY
 To test the cause of growth of price level (inflation), we yield
lnP = lnM + lnV - lnY
 To simplify our examining, we hold the growth rate of the
velocity of circulation of money (V) being constant (β0 ).
 Thus, we yield the regression like this:
lnP = β0 + β1lnM + β2 lnY
Sample
 Country: United States
 Period: 1959Q1 to 2010Q3
 Data:
 M is M2
 P is the GDP Deflator
 Y is the real GDP
Result
 We run a OLS estimation on the regression:
lnP = β0 + β1lnM + β2 lnY
The result is:
lnP = 2.918171 + 0.893281 lnM - 0.650627 lnY
(0.33306 )
(0.028347 )
R-squared = 0.992265
(0.061715 )
RSS = 0.603807
 We can conclude that the Quantity Theory of Money significantly
explain the cause of inflation
Test Whether 1973 Oil Crisis cause a structural
change
 1973 Oil Crisis lead the GDP growth of US decreased by
4.7%
 It shows that 1973 Oil Crisis is a serious economic shock for
US
 It is worth to test that whether 1973 Oil Crisis bring a
structural change (in term of the effect of the growth of
money supply and output to the inflation.)
Methodology
 The Chow test is used to do the test.
 Separate the whole period to two sub-periods:
 1959Q1 to 1973Q3
 1973Q4 to 2010Q3
 Establish the Hypothesis:
H0: No structural change, Var(1)=Var(2) =σ2
H1 :Yes, there is a structural change, Var(1)≠Var(2)≠σ2
• Run OLS on two sub-sample groups separately and obtain the
RSS1, and RSS2, (RSS1+RSS2=RSSUR)
Run OLS on the whole sample (N) and obtain the
restricted RSSR
 Compute:
 F* = [(RSSR - RSS1 RSS2)/k+1]/ (RSS1 +RSS2)/N-2k-2
 If F* > Fc , k+1, N-2k-2 ==> reject H0
 RSSR (Whole Period)= 0.603807
 RSS1 (1959Q1 to 1973Q3) = 0.029737
 RSS2 (1973Q4 to 2010Q3)= 0.445407
 By computation:
 F*= 18.14275 , where Fc =3.9491
 Where α=0.01
 Since F*= 18.14275 , Fc =3.9491
 F* > Fc , k+1, N-2k-2 ==> reject H0
 There is a structural change, Var(1)≠Var(2)≠σ2
 We can conclude that the effects of the growth of money supply
and output to the inflation have had a structural change after 1973
oil crisis!