Homework SourseThe following regression was conducted for the inflation rat
The following regression was conducted for the inflation rate information and exchange rate of the British pound:
Regression results taken directly from MS Excel indicate the following:
Coefficient Estimate
Standard Error
T stat
Intercept
0.54
0.12
5.00
Inflation Differential
0.34
0.33
2.50
Suppose that the critical t value is 2.5 or -2.5.
Show all calculations to justify your answers to the questions below
Do you have any evidence inconsistent with the Purchasing Power Parity theory? If there is evidence inconsistent with the Purchasing Power Parity theory, please show all evidence inconsistent with the Purchasing Power Parity theory.
| Coefficient Estimate | Standard Error | T stat | |
| Intercept | 0.54 | 0.12 | 5.00 |
| Inflation Differential | 0.34 | 0.33 | 2.50 |
Solution
Theories that invoke purchasing power parityassume that in some circumstances (for example, as a long-run tendency) it would cost exactly the same number of, for example,US dollars to buy euros and then to use the proceeds to buy a market basket of goods as it would cost to use those dollars directly in purchasing the market basket of goods.
The concept of purchasing power parity allows one to estimate what the exchange rate between two currencies would have to be in order for the exchange to be at par with thepurchasing power of the two countries\' currencies. Using that PPP rate for hypothetical currency conversions, a given amount of one currency thus has the same purchasing power whether used directly to purchase a market basket of goods or used to convert at the PPP rate to the other currency and then purchase the market basket using that currency. Observed deviations of the exchange rate from purchasing power parity are measured by deviations of the real exchange rate from its PPP value of 1.
The overall regression looks acceptable. We can reject the null hypothesis that the coefficient estimate is equal to 0 at 1% level of significance which contradicts the PPP theory.We cannot reject the null hypothesis that the coefficient estimate is equal to 1 at 5% level of significance which supports the PPP theory.
