# Category Archives: Original Articles

## Introduction to Simple Linear Regression

In the previous article, we introduced the motivation behind econometrics and the role it plays in the field of economics. We also briefly discussed the concept of an econometric model, which was essentially an equation that captures the relationship between variables. Today we will leap further into the econometric discussion by examining the most fundamental model: Simple Linear Regression (SLR).

Suppose we have collected data for two variables, and we want to use a Simple Linear Regression model to estimate their relationship. The equation to link the two variables (let’s call them x and y) would be as follows (Wooldridge 21):

where:

• is the independent variable, or regressand
• is the dependent variable, or regressor
• is the intercept parameter
• is the slope parameter
• is the error term

Immediately, you may realize that this formula is near identical to the slope-intercept form of a line. Indeed, the idea behind the SLR model is produce a line that best represents the collection of data points (i.e. the regression line). We can denote the estimated line (also called a line of fitted values) as follows:

Notice that while , and are being estimated here, is not. This means we can plug in any arbitrary value for and the model will estimate a value for given our slope-intercept parameters. Another value we are particularly interested in is the residual. This is essentially the distance between a data point and our fitted line.

Source: Introductory Econometrics, A Modern Approach

We have yet to discuss how to obtain the estimates for the slope and intercept parameters. Though we have formulas for and , we still require and to calculate them. We will not divulge too much into the mathematical derivation, but it is important to understand the idea behind achieving the estimates.

Often, you will see the term OLS or ordinary least squares used in conjunction with simple linear regression. This refers to the method of estimating and . The idea behind this method revolves around the residual. Recall that the residual is the distance between a data point and the fitted value (on the line). The goal is to minimize the sum of squared residuals with respect to and , that is (Wooldridge 27):

We will need to take the partial derivatives with respect to and and set them to zero. The solution to the system of equations will minimize the sum of squared residuals. We call these following equations the first order conditions:

(1)

(2)

With some algebra, one can see that (Stock and Watson 115):

At this point, you may be overwhelmed with the theory and lack of practicality of the SLR model. Let us now consider an application of regressions in Finance using the capital asset pricing model:

captures the sensitivity of stock returns to changes in returns of the market portfolio (Brealey et al 386). For example, Apple’s current is reported at 1.32 (Google Finance) with respect to NASDAQ. If is bigger than 1, we know the stock has higher risk than that of the market portfolio. Conversely, is less than 1 suggests that the stock is less risky. The market portfolio always has a beta of 1.  As we can see, the capital asset pricing model looks similar to that of a simple linear regression model. If we include an error term, we can use OLS to estimate the parameter by regressing the equity risk premium on the market premium (Stock and Watson 118).

The Simple Linear Regression Model serves as a building block for many more complex models. In future articles, we will study the underlying assumptions in which the linear regression model depends upon. If those conditions fail, we will explore strategies to mitigate the potential issues that may arise during our regression analysis. Furthermore, we will see that this model can be extended to more than just one regressor.

Sources:

1. Brealey, Richard A., Stewart C. Myers, Alan J. Marcus, Devashis Mitra, and William Lim. Fundamentals of Corporate Finance. 6th ed. New York: McGraw-Hill, 2011. Print.
2. Stock, James H., and Mark W. Watson. Introduction to Econometrics. 3rd ed. Boston: Pearson/Addison Wesley, 2007. Print.
3. Wooldridge, Jeffrey M. Introductory Econometrics: A Modern Approach. 6th ed. Boston: Cengage Learning, 2013. Print.

## Trends in Corporate Lobbying: Its Incentives and Socio-Economic Effects

In sight of the White House, just across from Lafayette Square, lies the US Chamber of Commerce (AmCham) Foundation, which works to educate the public on the positive impacts of business. Such proximity signifies the intimacy of Congressional agenda-setting and its policy priorities with the lobbyists supporting unregulated, Big Business. Since the early 2000s, corporate lobbying has exceeded the Congressional budget, where \$2.6 billion per year is spent in such a manner [1]. This increasing corporate influence in US politics culminates in the ‘Citizens United vs. Federal Election Commission’ Supreme Court Case, which determined that campaign spending by organization should remain without a ceiling [2].

This is in stark contrast to the 1960s, when public interest groups and labor unions were highly significant actors and corporate lobbies remained limited and inefficient. The government had gone on a ‘regulatory binge’, but growing compliance costs, rising wages and slowing economic growth spurred the formation of the Business Roundtable. This lobbying group was formed by the most senior executives of American Big Business, with objectives to decrease labor costs and union power and increase the ‘international competitiveness of American industry’. By the early 1980s, lobbyists triumph with successful labor reform, loss of regulation and lower taxes, as exemplified by the Labor Reform Law of 1977 and Economic Recovery Tax Act of 1981 [1].

Lobbyists assumed a ‘leave us alone’ relationship with the government in Washington. This attitude shifted to ‘let’s work together’ in the late 1980s with the advent of ‘advocacy advertising’. These programs are aimed to shape the political landscape by creating commercials and media to “[procure] a political climate conducive to business as a whole” [3]. And this chumminess between politics and business was not privy to the US alone.

The global influence of AmCham grew with the Europeanization of American business interests, as American firms adopted policies to hire specific European nationals to lead on specific business issues. However, the early 1990s saw the growing influence of the European Round Table of Industrialists, and so grows the divide between the influence of European and American lobbyists [4].

The informality and flexibility of the European Commission allows for its lobbyists to conduct long-run business-government relationships. The intimate relationship between administration bureaucracies and the business environment is exemplified by a common interventionist policy that a European government and business has with the EU, where such a relationship is symbiotic in the sense that both parties would prosper by stepping up their regulatory initiatives in the EU Single Market [4]. Conversely, the US Market is at odds with consistent quarrels between Big Business and the government over business-inhibiting regulations and transparency measures.

European and American differences aside, lobbying influence is a growing trend that is easily perceived when considering particular lobbying strategies of firms. Note that, naturally, some interest groups may have divergent interests. If the policy goals of different groups are not consistent, let’s say between a Business group and a Labor group, the amount of lobbying on the issue increases due to various viewpoints. More significant is the ‘free-riding problem’, which occurs when some firms benefit from the work of an interest group in their lobbying attempts without being part of the lobbying. A common solution is that the benefits from lobbying can be allocated solely to participants of the collective action, though consequently lobbying participation and amount of lobbying funding will increase [5].

As firms are incentivized to lobby, the socio-economic effects are consequently more prevalent. With solutions to the ‘free-riding’ and divergent interest problems being provided by the theory of collective action, the result is rising aggregate profits. This corresponds to a decreasing wage share and stagnant wages for lower-income workers, compared to higher-income ones in the same corporation, resulting in greater wage inequality [7].

Top Graph: Employee Compensation and Corporate Profits // Bottom Graph: Wages to Profit Ratio [6]

This rise in profits could be a result of a decline in competition, especially with sustained long-term aggregate profits, and firms are able to increase their prices and lobby for favorable regulations rather than using the wholesome tool of innovation to compete with other firms [7].

The social critique aside, with the increasingly present politic-skewing effects of lobbying, Western leaders like Trudeau and Trump have taken steps to ostensibly consolidate their power. Canada’s Trudeau legislates a ban to cash-for-access lobbying [8], requiring transparent lobbying being the only means to do so, and America’s Trump ordering a Five-Year Ban on lobbying and a permanent ban to foreign lobbying [9]. This allows these leaders to keep the Parliamentary and Congressional agendas their own and undermine efforts of political opponents, but can also lead to trends back to more moderate political-business relationships that were witnessed in the 1970s.

With a highly centralized government comes the reliance of cities on international lending and corporate borrowing with tight regulation, and a susceptibility to a long-term market slowdown, as seen during the 1960s in the US. A highly decentralized government results in deregulation and increased reliance of cities on corporate borrowing, with the effects of lobbying becoming more discernible. Both these national strategies seem to ‘give the man fish, without teaching him how to fish’. The prioritization of business entrepreneurship as the primary growth strategy has resulted in declining industrial productivity, as exemplified by the US Rustbelt states, especially with government opposition to the strategy. Today, it seems as though governance would rather be ‘the hand that feeds us’ rather than ‘teaching us how to fish’.

And so a tenacious tone rings through and is epitomized by the words of Napoleon Bonaparte at the dawn of the industrial revolution, when he says, “When a government is dependent upon bankers for money, they and not the leaders of the government control the situation, since the hand that gives is above the hand that takes” [10].

Sources:

## The Projected Effects of Dutch Disease

In 2016, the world witnessed as Venezuela fell into a large-scale economic collapse. For some, this implosion seemingly materialized from nowhere. In revision, its causes could be traced and explained by numerous factors, including economic mismanagement from its government, rigid socialist economic policies, and a fall in oil prices. A combination of the listed factors provoked a phenomenon known as Dutch disease, which plagues the Venezuelan economy in a predicament which continues to strain the country and its citizens.

So what is Dutch disease? First coined by The Economist in 1977, the term was used to describe the effects on the Dutch economy after large deposits of natural gas were discovered in the province of Groningen in 1959. The term is most commonly applied to the discovery of natural resources such as oil and gas, but generally can refer to any situation where a large flow or investment of foreign currency into a country’s economy leads to the rapid appreciation of its currency due to its rising demand. Referring back to Groningen, the discovery increased exports in natural gas, which led to a substantial inflow of foreign currency in exchange for the guilder (the Netherlands’ currency at the time).

At first glance, this phenomenon is seemingly harmless, perhaps even beneficial, to the Dutch economy. In fact, some economists argue that Dutch disease is no disease at all, as it could be said that economies should focus on exporting commodities in which it is most efficient at producing. Furthermore, a stronger guilder makes it cheaper for the Dutch to purchase foreign goods.

However, in lagging sectors such as agriculture or manufacturing (lagging describes a sector with little and/or slow growth), appreciation of a currency makes it more expensive for foreign countries to import goods from these industries, leading in a decrease in global competitiveness. Equivalently, the large inflow of currency from exports increases the money supply domestically (assuming no intervention in monetary policy), which allows for citizens to afford more domestic goods, which inevitably leads to a rise in prices. In other words, the real exchange rate rises, once again making it harder for foreign countries to afford goods from these less dominant industries.

where stands for exchange rate, is domestic prices, and is foreign prices

So what does this mean for an economy overall? A boom in one industry damages competitiveness for non-related industries globally due to the appreciation in currency, making a country increasingly reliant on a single dominant export. For countries that export an abundant resource (examples include Nigeria and Kuwait, to name a few), issues may arise when reserves dry up, it becomes economically infeasible to export, leading to a decline in revenue. The loss in revenue is difficult to recover alternatively through exports in lagging industries that have been weakened due to a resource boom.

Venezuela’s economy came crashing down when its decade-long reliance on oil exports reared its head after OPEC decided to increase supply and production, which caused global prices to drop significantly. Its citizens, who have lived prosperously through social and welfare programs funded by revenues from their state-owned oil enterprise (the PDVSA), were greatly affected by the decision. As oil made up over 90% of Venezuela’s total exports [1], the drastic drop to approximately USD 30 per barrel at the start of 2016 from around USD 50 a year before (an even more drastic decrease when compared to appx. USD 100 per barrel from the start of 2014) [2] put a strain on revenues and production, cutting welfare for its people, as well as hindering its purchasing power of imports for  essential goods such as food.

Many lessons can be derived from these studies (which vary from case to case). But, the overarching message is the importance of diversifying an economy, and allowing for a fallback should consumers and producers tinker with the stability of markets. Definitely easier said than done.

Sources:

## IMF has Positive Outlook for Canada’s Economy in 2017

Last Monday, the IMF improved the outlook for the Canadian Economy [1] – which will be welcome news after a sluggish period since late 2014. The IMF projects that Canada’s economy will grow by 1.9% and 2.0% respectively in 2017 and 2018.

Canada is also expected to outperform every G7 country except for the United States. Most of the adjustments are a result of the 2016 US election – and the IMF believes Canada will come out of a Trump presidency relatively fine, though it is still early to tell.

President Trump’s presence dominates most of the report, as shown by Mexico’s growth projection – it’s economy is expected to slow to a 1.7% increase.

For advanced economies, in general, the IMF suggested policies that fight the low inflation that plagues negative output countries, and to enact policies that will help long-term potential output. For example, tax reform and the strengthening of safety nets.

A lot of the positivity for the Canadian Economy comes from the stabilization of commodity pricing, and general positivity for all advanced economies.

However, it is far from all good news for the Canadian economy. The loonie looks to be in for a rough year [2]. As the US appears ready to ready to hike interest rates, the loonie will likely fall – as you will have learned from your introductory Macroeconomics courses.

Then, there is the issue of President Trump’s unpredictable policies. These concerns are further enforced in the IMF report, saying “[…]there is a wide dispersion of possible outcomes around the projections, given uncertainty surrounding the policy stance of the incoming U.S. administration and its global ramifications.” If President Trump decides to govern with a protectionist agenda, it will undoubtedly be bad news for Canada.

Overall, there is enough evidence to be cautiously optimistic for the Canadian economy.

REFERENCE

[1] http://www.imf.org/external/pubs/ft/weo/2017/update/01/pdf/0117.pdf

## Japan’s Negative Interest Rate Story

Bank of Japan in Chūō, Tokyo

Central Banks around the world have wrestled with low-interest rates, but nowhere have they grappled with them for longer than in Japan [5]. Investment in Japan as a percentage of GDP has been on a downward trend for more than two decades. To combat these persistent bouts of deflation, the Bank of Japan (BoJ) pioneered a monetary strategy known as “quantitative easing” (QE). The main function of QE is to depress long-term interest rates by buying vast amounts of government bonds through printed currency [1].

Employing this technique led the BoJ to introduce negative interest rates in January 2016. Although this was 20 months after negative rates were first issued by the European Central Bank (ECB), Japan had already faced stagnated interest rates, reaching as low as 0%, since 1999 [5]. Prior to entering 2017, Japan once again reviewed their monetary policy in hopes to kick-start growth, as intended for the past two decades. After the two-day policy meeting in December 2016, the BoJ left that policy unchanged, planning to: maintain the negative 0.1% interest rate on excess bank reserves, leave the 10-year Japanese Government Bond (JGB) at a yield target of 0 bps, and keep annual rises in JGB holdings to 80 trillion yen (676.9 billion USD) [4].

The implications of negative interest rates mean depositors must pay money to set aside reserves, which is a reversal of the common understanding of economics [1]. Depositors are commonly known as banks, and their relationship with the Central Banks are similar to regular people who keep accounts at a local bank. This relationship normally allows depositors to receive a small amount of interest in return for leaving their money with the Central Bank. However, with the introduction of negative rates, Central Banks charge depositors a negative rate on principal kept in excess reserves. This strategy is meant to encourage the productive utility of money for depositors by lending more frequently to consumers and businesses. Negative rates are then supposed to send a ripple effect through the economy by lowering the cost of borrowing for everyone – which should in turn stimulate economic growth [1].

Japan’s core inflation rate since 1971.

Japan has been dealing with low-interest rates since 1995, never moving higher than the 0.5% rate which was slashed to zero in 1999. Despite the lower borrowing costs, consumer demand has weakened, which created deflationary pressure on the country [2]. “There should be some threshold where corporations will start to take cash out of their vaults and put it to work,” said Masaaki Kanno, Japan chief economist at J.P. Morgan. The solution the BoJ seeks is to drop its benchmark rate further, in an attempt to trigger inflation. It is conceivable that rates may drop to as low as -0.7% [2].

The greatest difficulty the BoJ now faces is timing. As the U.S. Federal Reserve announced their first of several rate hikes in 2017, the consequences are still unknown for Japan. Additionally, the yen has tumbled 10% percent post-U.S. election. A weaker yen generates inflationary pressures through higher import costs and greater corporate profits: in turn this diminishes the effectiveness of Japan’s monetary policy [3]. A premature rate hike might risk increasing the strength of the yen, making it much more difficult to reach the inflation target. As Heizo Takenaka, a professor at Toyo University and Japan’s former Minister of State for Economic and Fiscal policy puts it best, “Despite the criticisms of negative interest rates, Japan lacks alternatives” [2].