ECON 2300: INTRODUCTORY ECONOMETRICS
Research Project 2
Due: 4 pm, 5 June
Submission of your report
Your report must be single-spaced and in 12 Font size. You should give your answer to each of the
following questions following a similar format of the solutions to the tutorial problem sets. When you
are required to use R, you must show your R command and R outputs (screenshots or figures gener-
ated from R). You will lose 2 points whenever you fail to provide R commands and outputs. For each
question, when you are asked to discuss or interpret, your answer has to be brief and compact. You
will lose 2 points if your answer is needlessly wordy. You must upload your assignment on the course
webpage (Blackboard) in PDF format. (Do not submit a hard copy.)
This project has two research questions. You are required to investigate both of them.
Problem 1: money, Growth, and Inflation (30 marks)
Background
To examine the quantity theory of money, Brumm (2005) [“Money Growth, Output Growth, and
Inflation: A Reexamination of the Modern Quantity Theory’s Linchpin Prediction,” Southern Economic
Journal, 71(3), 661–667] specifies the inflation equation
inflat = β1 + β2money+ β3output+ u
where inflat is the growth rate of the general price level, money is the growth rate of the money
supply, and output is the growth rate of national output. Economic theory suggests that β2 = 1 and
β3 = ?1. The dataset brumm.dta consists of 1995 data on 76 countries.
Research tasks
1. It is argued that output may be endogenous. Four instrumental variables are proposed, initial
= initial level of real GDP , school = a measure of the population’s educational attainment, inv
= average investment share of GDP , and poprate = average population growth rate.
(a) Give an intuitive explanation as to why output can be endogenous (3 marks)
(b) Explain why the proposed IVs can be valid. (6 marks, i.e., 2 marks for understanding of
valid IVs and 1 mark for convincing story for each IV)
2. Using the four IVs, obtain TSLS estimates of the inflation equation (4 marks), and test the
economic theory using the IV estimates (4 marks).
3. Determine whether the IVs are strong or not (3 marks) and test if they are exogeneous (3 marks).
4. Present a short research note (less than a half page) of your findings. You are allowed to use your
previous findings here again or to estimate again the model using a different set of IVs (7 marks).
1
Problem 2: Demand for Democracy (70 marks)
Background:
Do citizens demand more democracy and political freedom as their incomes grow? That is, is democ-
racy a normal good? To investigate this issue, you will explore the dataset Income Democracy.dta
which contains a panel data set from 195 countries for the years 1960, 1965, ... , 2000. A detailed
description is given in Income Democracy Description.pdf.1 The dataset contains an index of politi-
cal freedom/democracy for each country in each year, together with data on the country’s income and
various demographic controls. (The income and demographic controls are lagged five years relative to
the democracy index to allow time for democracy to adjust to changes in these variables.)
Research tasks:
1. Is the data set a balanced panel? Explain. (5 marks)
2. The index of political freedom/democracy is labeled dem ind.
(a) What is the value of dem ind for the United States in 2000? What is the average of dem ind
for the United States over all years in the data set? (4 marks) Repeat this exercise for Libya
(2 marks).
(b) List five countries with an average value of dem ind greater than 0.95; less than 0.10; and
between 0.3 and 0.7. (5 marks)
3. The logarithm of per capita income is labeled log gdppc .
(a) Regress dem ind on log gdppc using standard errors that are clustered by country (3 marks).
(b) How large is the estimated coefficient on log gdppc? Is the coefficient statistically signifi-
cant? (2 marks)
(c) If per capita income in a country increases by 20%, by approximately how much is dem ind
predicted to increase? What is a 95% confidence interval for the prediction? Is the predicted
increase in dem ind large or small? Explain what you mean by large or small. (5 marks)
(d) Why is it important to use clustered standard errors for the regression? Do the results
change if you do not use clustered standard errors? (4 marks)
4. (a) Suggest a variable that varies across countries but plausibly varies little–or not at all–over
time and that could cause omitted variable bias in the regression in Question 3 above. (5
marks)
(b) Estimate the regression in Q3, allowing for country fixed effects. How do your answers to
Q3(b) and Q3(c) change? (5 marks)
(c) Exclude the data for Azerbaijan and rerun the regression. Do the results change? Why or
why not? (5 marks)
(d) Suggest a variable that varies over time but plausibly varies little–or not at all–across coun-
tries and that could cause omitted variable bias in the regression in Q3. (5 marks)
(e) Estimate the regression in Q3, allowing for time and country fixed effects. How do your
answers to Q3(b) and Q3(c) change? (5 marks)
(f) There are addition demographic controls in the data set. Should these variables be included
in the regression? If so, how do the results change when they are included? (5 marks)
5. Based on your analysis, what conclusions do you draw about the effects of income on democracy?
(10 marks)
1These data were provided by Daron Acemoglu of M.I.T. and were used in his paper with Simon Johnson, James
Robinson, and Pierre Yared, “Income and Democracy,” American Economic Review, 2008, 98:3, 808–842.