1. Macroeconomic theory postulates two alternative specifications to test the validity of the purchasing power parity...

  

Transcribed Image Text:

1. Macroeconomic theory postulates two alternative specifications to test the validity of the purchasing power parity (PPP) hypothesis: (1) et Bo+ Pipdt + ut = (2) Aet yıApd + Vt where, e = (log) nominal exchange rate, p = (log.) domestic price level, p* = (log.) foreign price level, pd = p-p*, Aetet - et-1 and Apdt = pdt - pdt-1. = The "Absolute PPP" holds if ß1 = 1 and ut is a white-noise process. The "Relative PPP” holds if y 1 = 1 and vt is a white-noise process. The following equations are estimated using 40 annual observations. MODEL A et = 0.04 +0.95pdt (2.13) (4.50) MODEL B MODEL C Aet = 0.05Apdt (2.05) R² = 0.75, DW = 0.40, LM(AR(1)) = 6.6, SSR = 1000 MODEL D (C-O): et = 0.05 +0.94pdt (2.40) (10.8) R2=0.35, DW = 3.6, LM(AR(1)) = 11.9, SSR=1400 et = 0.02 +0.58pdt +0.20et-1 +0.28pdt-1 (2.10) (5.06) (2.20) (2.45) R2 = 0.95, DW = 2.0, LM(AR(1)) = 0.5, SSR = 400. R2 = 0.98, DW = 1.9, SSR = 300. LM(AR(1)) is the LM tests for AR(1). Model D is estimated by Cochrane-Orcutt (C-O) iterative procedure. The values in parentheses are the t-ratios. i) Test the validity of the absolute and relative PPP hypotheses. ii) Explain why the researcher estimated Model B. Considering Models A and C, state the maintained hypotheses for the estimation of Model B. Are these hypotheses supported by the data? iii) Explain why the researcher estimated Model D. What are the maintained hypotheses for the estimation of this model? What did the researcher hope to achieve? Did the researcher succeed? iv) Compare all the estimated models. Which model do you prefer? Why? 1. Macroeconomic theory postulates two alternative specifications to test the validity of the purchasing power parity (PPP) hypothesis: (1) et Bo+ Pipdt + ut = (2) Aet yıApd + Vt where, e = (log) nominal exchange rate, p = (log.) domestic price level, p* = (log.) foreign price level, pd = p-p*, Aetet - et-1 and Apdt = pdt - pdt-1. = The "Absolute PPP" holds if ß1 = 1 and ut is a white-noise process. The "Relative PPP” holds if y 1 = 1 and vt is a white-noise process. The following equations are estimated using 40 annual observations. MODEL A et = 0.04 +0.95pdt (2.13) (4.50) MODEL B MODEL C Aet = 0.05Apdt (2.05) R² = 0.75, DW = 0.40, LM(AR(1)) = 6.6, SSR = 1000 MODEL D (C-O): et = 0.05 +0.94pdt (2.40) (10.8) R2=0.35, DW = 3.6, LM(AR(1)) = 11.9, SSR=1400 et = 0.02 +0.58pdt +0.20et-1 +0.28pdt-1 (2.10) (5.06) (2.20) (2.45) R2 = 0.95, DW = 2.0, LM(AR(1)) = 0.5, SSR = 400. R2 = 0.98, DW = 1.9, SSR = 300. LM(AR(1)) is the LM tests for AR(1). Model D is estimated by Cochrane-Orcutt (C-O) iterative procedure. The values in parentheses are the t-ratios. i) Test the validity of the absolute and relative PPP hypotheses. ii) Explain why the researcher estimated Model B. Considering Models A and C, state the maintained hypotheses for the estimation of Model B. Are these hypotheses supported by the data? iii) Explain why the researcher estimated Model D. What are the maintained hypotheses for the estimation of this model? What did the researcher hope to achieve? Did the researcher succeed? iv) Compare all the estimated models. Which model do you prefer? Why?

Answer rating: 100% (QA)

i Test the validity of the absolute and relative PPP hypotheses The absolute PPP hypothesis states that the nominal exchange rate between two currencies is equal to the ratio of the price levels of th... View the full answer