Macroeconomic theory postulates two alternative specifications to test

the validity of the purchasing power parity (PPP) hypothesis:

(1) et = Ξ²0 + Ξ²1pdt + ut

(2) Ξet = Ξ³1Ξpdt + vt

where, e = (log) nominal exchange rate, p = (log.) domestic price level, p* = (log.)

foreign price level, pd = p-p*, Ξet = et - et-1 and Ξpdt = pdt - pdt-1.

The βAbsolute PPPβ holds if Ξ²1 = 1 and ut is a white-noise process.

The βRelative PPPβ holds if Ξ³1 = 1 and vt is a white-noise process.

The following equations are estimated using 40 annual observations.

MODEL A et = 0.04 + 0.98pdt

(2.13) (2.50)

R2 = 0.60, DW = 3.40, LM(AR(1)) = 19.6,

LM(WHITE)) = 1.4, SSR = 100

MODEL B Ξet = 0.95Ξpdt

(2.05)

R2 = 0.30, DW = 1.9, LM(AR(1)) = 0.9

LM(WHITE) = 15.4, SSR = 1000

MODEL C et = 0.02 + 0.80pdt + 0.20et-1 + 0.40pdt-1

(2.10) (5.06) (3.20) (2.45)

R2 = 0.80, DW = 2.1, LM(AR(1)) = 0.5,

LM(WHITE) = 0.8, SSR = 20.

MODEL D (C-O): et = 0.05 + 0.94pdt

(2.40) (10.8)

R2 = 0.98, DW = 1.9, LM(AR(1)) = 0.5

SSR = 100 LM(WHITE) = 11.1

Model D is estimated by Cochrane-Orcutt (C-O) iterative procedure. The values in

parentheses are the t-ratios.

i) Β Test the validity of the absolute and relative PPP hypotheses.

ii) Β 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) Β 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?