Use the data in INTDEF 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 5 b0 1 b1inft 1 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 inft21 as an IV for inft

. How does the IV estimate of b1 compare with the OLS estimate?

(iii) Now, first difference the equation:

Di3t 5 b0 1 b1Dinft 1 Dut

.

Estimate this by OLS and compare the estimate of b1 with the previous estimates.

(iv) Can you use Dinft21 as an IV for Dinft in the differenced equation in part (iii)? Explain.

(Hint: Are Dinft and Dinft21 sufficiently correlated?)