Written by G. Godsell & V. Tran
Submitted to Professor Kathleen Day
for the course Introduction to Econometrics
University of Ottawa, December 6, 2011
In light of major events in the United States’ economy since mid-2007 and the related behaviors of interest rates, commodity prices, unemployment and national debt, we will determine in this paper the nature of the relationship between these variables and their potential implications for future fiscal policy. Using a regression analysis of gold prices, we will gain a clearer understanding of how gold’s price behaviour can be explained. We expect that our regression analysis will confirm our hypothesis that fiscal policies attempting to stimulate investment and growth by lowering nominal interest rates may contribute significantly to asset bubbles through their effect on commodity prices, such as gold. Our analysis of gold prices from the past 41 years (1970-2010) will test our opinion by demonstrating how commodity prices in general have been impacted by changes in the interest rate.
Our hypothesis attempts to identify the impact that manipulating interest rates can have on the economy. In the short term, they can provide some stimulus to the economy by lowering borrowing costs. This incentive often encourages businesses and consumers to make additional purchases of capital goods and make other significant investments, such as property or equipment renovations. Once the purchaser spends the money, there is usually a stimulating effect on the economy, as people must be hired to build the good or provide the service.
It is also our belief that low interest rate policies may also create inflationary pressure. This is because the total cost in dollars for something that can be bought at a lower interest rate can be much less than the same item when interest rates are high. Oftentimes this may be the difference between being able to afford an item, such as a car, or not afford the item. If the cost of money (interest) remains low for an extended period of time, then it is possible for consumers to bid up the prices for these goods and services.
It is our belief that as interest rates decrease and, consequently, the cost of money decreases, the more people are able to purchase fixed assets such as gold. In other words, gold price is driven upwards as there is less opportunity cost associated with buying gold when interest rates are low. During periods of low interest rates, owning an asset that does not directly provide a revenue stream (i.e. dividends or bond yields) may be less problematic. If more people can afford the higher price, then there is usually some corresponding inflationary pressure. We expect that this inflationary pressure will be reflected in our analysis of gold prices against other variables.
Mathematical Representation of the Regression Equation
The regression equation we use in our initial analysis is specified as follows:
The latter sections of this paper will also discuss an alternate regression equation, which is a necessary re-specification of the above in response to poor initial regression results. Discussing this latter equation in tandem with the initial model is useful to compare our expectations of the additional coefficients, as well as to define the added variables early on. Later, we will see that this allows us to examine both regression results in clearer and greater depth. As we will illustrate later, the alternate equation performs far better in its explanatory power and interpretation. The latter equation includes gold production and additional macroeconomic measures that may influence gold demand. Thus, references to Equation 1 in the rest of the paper will now refer to the equation above. References to Equation 2 will then refer to the following model specification:
Where the definitions of GOLDt, INTRt, MONt, RSCNt, DEBTt, LGPRODt, and EMPRt are: