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Econometrics and Purchasing Power Parity - Assignment Example

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The purpose of this paper "Econometrics and Purchasing Power Parity" is to test the theory underlying purchasing power parity. A regression model will be used to test the strength and direction of the relationships between foreign and domestic inflation rates with the change in the growth rate. …
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Econometrics and Purchasing Power Parity
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Download file to see previous pages A variety of diagnostics tests are then done on the regression in order to determine its validity. Finally, one of PPP’s underlying assumptions is tested by conducting t-tests on the coefficients of the regressors.

In its initial form, PPP holds that a bundle of goods in the two countries should cost the same when inflation is taken into account. The major difference between this and relative PPP is that the latter incorporates the inflation rates in each country and suggests that these have a role to play in determining changes in the growth rate of the exchange rate between two countries. Relative PPP tends to focus on the long-run, and it holds that “over long periods of time exchange rates will tend to offset the differences in inflation rates between the two countries whose currencies comprise the exchange rate” (Simonoff 2006: 1).

A brief survey of the literature shows that PPP is hardly a theory that is widely accepted in the academic world. In fact, Simonoff (2006: 15) points out that for developing countries, the robustness of the principles of PPP is questionable. This is likely to be a problem in this assignment’s regression as the two countries in question – the US and Sri Lanka – are developed and developing respectively.

This seemingly grey outlook is shared by many academics1 and Suranovic (1997: n.p.) goes so far as to say that “in general, the PPP theory holds miserably when applied to real-world data.” This assignment will test whether this opinion is justified or not. The next section briefly introduces the data before embarking on the analysis.

The data was sourced from the United Nations statistical database and from the Penn World Tables. The sample period runs from 1950 to 2006 and all data is annual. The fact that the data is annual means that seasonality is not a concern.

It was necessary to construct a variable capturing the growth rate of the exchange rate over time and so the CHANGEX variable was generated by simply dividing the first differenced exchange rate variable by the exchange rate variable.   ...Download file to see next pagesRead More
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