Use the data in PHILLIPS for this exercise.

(i) In Example 11.5, we estimated an expectations augmented Phillips curve of the form Dinft 5 b0 1 b1unemt 1 et

, where Dinft 5 inft 2 inft21. In estimating this equation by OLS, we assumed that the supply shock, et

, was uncorrelated with unemt

. If this is false, what can be said about the OLS estimator of b1?

(ii) Suppose that et is unpredictable given all past information: E1et 0inft21, unemt21, p2 5 0.

Explain why this makes unemt21 a good IV candidate for unemt

.

(iii) Regress unemt on unemt21. Are unemt and unemt21 significantly correlated?

(iv) Estimate the expectations augmented Phillips curve by IV. Report the results in the usual form and compare them with the OLS estimates from Example 11.5.