Purchasing power parity hypothesis postulates that nominal exchange rate growth (NER) in a country is positively related to domestic inflation rate (Π) and negatively related to foreign inflation rate (Π*): NERt = a0 + a1Πt + a2Π*t + ut
NERt = a0 + a1Πt + a2Π*t + ut
where u is a disturbance term. Under certain conditions, ER can be defined as a function of inflation differential ΠD = Π - Π*. Some researchers often prefer to explain real exchange rate change which is defined as RER = ER – Π. Using a sample of 50 annual observations, a researcher estimates the following equations.
(1) NERt = 0.19 + 0.96Πt - 0.80Π*t R21 = 0.90, SSR1 = 900
(0.01) (0.24) (0.10)
(2) NERt = 0.15 + 0.64ΠDt R22 = 0.89, SSR2 = 901
(0.03) (0.10)
(3) RERt = 0.05 – 0.95 Π*t R23 = 0.60, SSR3 = 905
(4) NERt = b0 + b1ΠD t + b2Π*t
(0.02) (0.03) (0.24)
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