Econometrics II Homework No.

An Empirical Study of Purchasing-Power Parity Theory Determination of Exchange Rate

Adrian Campos1
(A8EB1078)

adriancdperu@yahoo.com

I.
1.1

Creating the Data Set

Original Data Set
Year Exchange Rate(Yen/$)  1972 1973 1974 1975 1976 1977 1978 1979 1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 306.6 268.9 292.1 296.8 296.5 268.5 210.4 219.1 226.7 220.5 249.1 237.5 237.5 238.5 168.5 144.6 128.1 138.0 144.8 134.5 126.7 111.2 102.2 94.1 108.8 121.0 130.9 113.8 107.7 121.5 Japan 100.0 109.3 148.1 158.9 163.8 171.2 168.2 166.9 203.8 209.8 215.2 213.6 210.8 213.6 198.3 182.8 180.9 181.3 188.1 190.9 187.5 182.8 177.3 175.9 175.6 178.3 177.3 170.4 170.6 166.6 Wholesale Price indices USA 100.0 108.6 127.7 146.4 153.6 162.5 172.6 191.4 221.4 245.8 255.1 256.8 264.6 264.3 260.4 258.3 268.2 283.9 293.2 300.6 296.7 303.0 305.7 316.1 323.5 325.4 316.6 310.7 328.6 332.5

2002 2003 2004 2005 2006 2007 2008 2009

125.3 115.9 108.2 110.2 116.3 117.8 103.3 93.5

163.2 161.7 163.9 166.6 170.2 173.2 181.1 171.6

324.7 342.3 363.3 389.8 408.2 427.7 469.8 428.4

1.2

Creating the data file for the regression analysis

Exchange Rate(Yen/$): E Japan Wholesale Price Index: PJ America Wholesale Price Index: PUS

In E-views, we call:

We define: y=log(E), x=log(PJ)-log(US) In our regression equation, y will be considered as the dependent variable and x will be considered as the independent variable.

II.

Graphical Examinations
Plot the movement of Yi against the calendar year

2.1

Y
5.8 5.6 5.4 5.2 5.0 4.8 4.6 4.4 1975 1980 1985 1990 1995 2000 2005

2.2 Comparison of the price index movements between Japan and the USA. Plot the Pji and Pusi against the year by setting the intial values of both Japan and the USA at 100 In E-views, this is: Pj 1972=PU1972=100
480 440 400 360 320 280 240 200 160 120 80 1975 1980 1985 1990 PJ 1995 PUS 2000 2005

2.3

Comparison of the movements of exchange rates and differences of log-price indexes between Japan and the USA.

We plot Yi and Xi against i (i is ith year).

6 5 4 3 2 1 0 -1 -2 1975 1980 1985 1990 Y 1995 X 2000 2005

2.4

Scatter diagram,
5.8 5.6 5.4 5.2 Y 5.0 4.8 4.6 4.4 -1.0

-0.8

-0.6

-0.4 X

-0.2

0.0

0.2

III.

Regression Analysis
Run E-views 7 to get the estimates of coefficients. Draw the regression line.
5.8 5.6 5.4 5.2 Y 5.0 4.8 4.6 4.4 -1.0

3.1

-0.8

-0.6

-0.4 X

-0.2

0.0

0.2

Coefficient Estimates
Variable C Coefficient 5.524916 1.125910 0.852928 0.848842 0.152328 0.835342 18.61284 208.7775 0.000000 Std. Error 0.040698 0.077922 t-Statistic 135.7555 14.44913 Prob. 0.0000 0.0000 5.057679 0.391801 -0.874360 -0.788171 -0.843695 0.438864

R-squared Adjusted R-squared S.E. of regression Sum squared resid Log likelihood F-statistic Prob(F-statistic)

3.2

Are your estimates significant?

Y= 5.52 + 1.13X (0.04) (0.08)

Our Simple Regression Equation is described as:

Let us focus at the t-Statistic values for our two coefficient estimates. Given this sample of 38 values, we use the Student-t distribution for 36 degrees of freedom to get t-statistics for each estimate. For standard error) is 135.7555 and for
0 = 5.52 the t-statistic (ratio of the estimated coefficient to its

bigger than 2, and both t-statistic values have p-values equal to 0 in the t-distribution (they do not fall out of the distribution, considering a t-statistic of 2 corresponds approximately to a p-value of 0.05). Therefore, we can say these estimates are very significant.

3.3

Testing Hypothesis
=1.0 vs. H 1:
Test Statistic t-statistic F-statistic Chi-square

We test Ho:

Null Hypothesis: C(2)=1 Null Hypothesis Summary:

Mean dependent var S.D. dependent var Akaike info criterion Schwarz criterion Hannan-Quinn criter. Durbin-Watson stat

=1.13 the t-statistic is 14.45. Both t-statistic absolute values are far

Value 1.615838 2.610933 2.610933

df 36 (1, 36) 1

Probability 0.1149 0.1149 0.1061

Normalized Restriction (= 0) -1 + C(2) Restrictions are linear in coefficients.

Value 0.125910

Std. Err. 0.077922

The t-static is 0.126, far bigger than 2 (critical value), so it does fall in the confidence interval. Thus, this null hypothesis is accepted easily. The PPP Theory holds for the exchange rates of the Japanese Yen to the US dollars, since a very important proposition employed in PPP Theory is the Law of One Price (the price of a certain product must be the same in every market). Theoretically, considering y=log(E), x=log(PJ)-log(US), according to PPP: Y=1.0X (that is But empirically: Then, when holding Ho: Y= 5.52 + 1.13X =1.0, the Null Hypothesis fails to be rejected. Thus, PPP Theory holds. =1.0 and
0=0.0)

(Intuitively, the coefficient estimate I got is 1.13, not far away from 1.0)

3.4

Predict Yi given the independent variable Xi for i=1,,n.

58 56 54 52 50 48 46 44

3.5

Comments on the empirical study

Our regression equation Y= 5.52 + 1.13X (in blue at 3.4) does tend to predict the real values of Y. Let us analyze this in more detail: To begin with, let us focus on the R-squared value: 0.85. This means that 85% of movements in Y can

1975

1980

1985

1990

1995 Y

2000

2005

be explained by movements in X, which indicate us that we might have done well in explaining Y in terms of X. The 15% missing is counted in the residuals.
. . . . .

. . . -. -.

Residual

Actual

Fitted

The estimated coefficients 5.52 and 1.13 also have adequate t-statistic values and p-values. There, this econometric regression confirms the veracity of the PPP Theory, to some extent. However, this empirical study does have some limitations. I shall briefly mention some, since the techniques used to analyze the limitations are far beyond the scope of this homework: -

Omitted variable bias It is possible that we might be omitting an important variable in the analysis. After all, there is still a 15% of Y movement that cannot be explained by X. An example: Y= 0 + X + Z Where Z is an important factor omitted in the analysis. (E.g: Relative Inflation, etc)

What have we proved and what have we not proved? Let us remember that this work does not probe causality (X causes Y). For one thing, X and Y are slightly correlated. Looking at the covariance matrix:
Y Y X 0.1494684697959855 0.113229128359262 X 0.113229128359262 0.1005667817556536

Cov(X,Y) is 0.113, different from zero. Now, does X cause Y? This is false since Y might have effect on X and X might have effect on Y at the same time. There could be a reverse causality issue.

           

It is possible, also, to consider the following scenario: There might be an external variable causing X and Y at the same time. A deep, more robust econometric analysis would be needed to analyze these issues.