FILE The Phillips curve is regarded as a reliable tool for forecasting inflation. It captures the inverse relation between the rate of unem ploym ent and the rate of inflation; the lower the unem ploym ent in an economy, the higher is the inflation rate. Consider the follow ing portion of m onthly data on seasonally adjusted inflation and unem ploym ent rates in the United States from January 2009 to November 2010.

The fu ll data set can be found on the text website, labeled P hillips Curve.

Year Month Unemployment Inflation 2009 Jan 7.7 0.3 2009 Feb 8.2 0.4

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2010 Nov 9.8 0.1 SOURCE: Bureau o f Labor Statistics.

a. Estimate tw o 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.