C15.4 Use the data in INTDEF.RAW for this exercise. A simple equation relating the three-month T-bill rate to the inflation rate (constructed from the Consumer Price Index) is i3t
0  1inft  ut . (i) Estimate this equation by OLS, omitting the first time period for later comparisons. Report the results in the usual form. (ii) Some economists feel that the Consumer Price Index mismeasures the true rate of inflation, so that the OLS from part (i) suffers from measurement error bias. Reestimate the equation from part (i), using inft1 as an IV for inft . How does the IV estimate of 1 compare with the OLS estimate? (iii) Now, first difference the equation: i3t
0  1inft  ut . Estimate this by OLS and compare the estimate of 1 with the previous estimates. (iv) Can you use inft1 as an IV for inft in the differenced equation in part (iii)? Explain. (Hint: Are inft and inft1 sufficiently correlated?)