The Phillips curve is regarded as a reliable tool for forecasting inflation. It captures the inverse relation between the rate of unemployment and the rate of inflation; the lower the unemployment in an economy, the higher is the inflation rate. Consider the following portion of monthly data on seasonally adjusted inflation and unemployment rates in the United States from January 2009 to November 2010. The full data set can be found on the text website, labeled Phillips Curve.
a. Estimate two models, of order 1 and 2, using unemployment as the response variable and lagged inflation as the explanatory variable(s). Should you use either model for forecasting unemployment? Explain.
b. Estimate autoregressive models of order 1 and 2 on unemployment. Choose the appropriate model to make a forecast of unemployment for December 2010.