Hussain Al-Mustafa
FIN 480 – International Finance
Costanza Meneghetti
Test of Theories: Purchasing Power Parity & International Fisher Theory- 2nd Draft
11/11/2013
Turkey
Al-Mustafa 2
Introduction
The paper tests two theories of macroeconomics – namely, Purchasing Power
Parity & International Fisher Theory – through use of real life economic data. Testing of
the theories is carried out through statistical analysis of historical economic data of UK,
Turkey and USA. The objective is to assess veracity of the economic theories by
evaluating inflation, exchange rate and interest rate of selected countries through
statistical tool of regression analysis.
Discussion
The first theory which is tested is the relationship between Purchasing Power
Parity and economic growth. Purchasing Power Parity is a method used in economics to
make a comparison between countries by bringing them to a unified measure. The
purchasing power of a given amount of money depends on effect of cost of living. In
other words, the general level of prices.is used to measure how much a currency in order
to buy goods and services in each of the areas being compared. The exchange rate PPPs
are used primarily in international comparisons of living standards. International
comparisons of GDP leads to not take into account differences in prices between
countries. The differences between the exchange rate and the real exchange rate PPP can
be significant. Thus, when the yen, the Japanese currency is overvalued, GDP per capita
seems much higher than its U.S. counterpart, while measured in PPP, it is actually much
lower. The first hypothesis is given as under:
Hypothesis 1: UK’s exchange rate is negative correlated with inflation rate of the
economy
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The data for UK’s exchange rate and inflation rate is gained for the years 19982000. The regression on the data is run using MS Excel. The summary of regression data
is given below:
Regression Results
Regression Statistics
Multiple R
0.323216004
Adjusted R Square
0.063762612
Observations
24
Standard
Coefficients
Error
0.007410822 0.004020925
0.111881938 0.069838708
t Stat
1.843064241
1.602004694
Intercept - t value for hypothesized value of 0
X Variable 1 - t value for hypothesized value of
0
X Variable 1 - t value for hypothesized value of
1
1.843064241
1.602004694
15.92071177
Intercept
X Variable 1
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The graphical representation between the two variables is drawn through a best-fit
graph.
Regression of Changes in Exchange Rate vs.
Inflation Rate
0.0400
0.0300
0.0200
0.0100
-0.1000
-0.0500
0.0000
0.0000
-0.0100
0.0500
0.1000
0.1500
0.2000
-0.0200
-0.0300
-0.0400
-0.0500
Even though, a negative relationship is indicated by the best-fit line, the
correlation coefficient is only 0.3. Hence, the relationship between the two variables can
be termed as weak given that 24 observations are used in this correlation investigation.
Therefore, this hypothesis is not supported by the data.
The second hypothesis relates to International Fisher Theory. International Fisher
Effect is the economic theory that defines the relation between the change in bank interest
rates and changes in spot exchange rates. According to the international Fisher effect, the
difference in interest rates between the two countries should be an unbiased predictor of
future changes in cash rates. The theory states that the expected change in the spot
exchange rate between the two currencies is approximately equivalent to the difference
between the two countries' nominal interest rates for the period. Based on Fisher’s theory,
the hypothesis given below is proposed to be tested:
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Hypothesis 2: Changes in exchange rate of US dollar and Turkish Lira is
equivalent to changes in interest rates of the two economies (International Fisher Effect).
To test this hypothesis, the data for exchange rate of Turkish Lira against US
dollar is taken for the year 2005-2013. The reason data years before 2005 is not used is
data is not available. The second data set comprises of the inflation rate of the two
countries during the same time period. Again hypothesis is tested using regression
analysis.
Regression Results
Regression Statistics
Multiple R
R Square
Adjusted R Square
Standard Error
Observations
0.3292
0.1084
-0.0402
0.0928
8.0000
ANOVA
Regression
Residual
Total
df
1.0000
6.0000
7.0000
SS
0.0063
0.0517
0.0580
MS
0.0063
0.0086
F
0.7292
Significance F
0.4259
Intercept
0.181818182
Coefficients
0.7214
-0.2112
Standard Error
0.0791
0.2473
t Stat
9.1237
-0.8539
P-value
0.0001
0.4259
Lower 95%
0.5279
-0.8162
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Graphical representation of the relationship between the two variables is given as
under:
Regression of Interest Rates vs. Exchange Rate
0.9
0.8
0.7
0.6
0.5
0.4
0.3
0.2
0.1
0
0.000
0.100
0.200
0.300
0.400
0.500
0.600
The correlation between the two variables is 0.3, while the graph is a downward
sloping line. The second hypothesis is, thus, rejected. Fisher’s theory is not supported by
empirical data for Turkey’s and USA’s exchange rate and inflation rate.
Conclusion
The paper tested two theories of macroeconomics – namely, Purchasing Power
Parity & International Fisher Theory – through use of real life economic data. Testing of
the theories is carried out through statistical analysis of historical economic data of UK,
Turkey and USA. The first hypothesis pertaining to Purchasing Power Parity remains
undetermined. The second hypothesis related to Fisher’s theory is not supported by the
data.
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Citations
Lee, M. Purchasing Power Parity. Ohio: Dekker Publishing , 2005.
Madura, J. International Financial Management. New Jersey: Engage Publishing, 2008.
Mcdermott, J and P Cashin. An Unbiased Appraisal of Purchasing Power Parity. New
Jersey: Engage Publishing, 2003.
Sen, A and M Srivastava. Regression Analysis: Theory, Methods, and Applications.
Ohio: Springer Publishing, 2003.
Wang, G and C Jain. Regression Analysis: Modeling & Forecasting. New York: John
Wiley & Sons, 2010.