Macroeconomic theory postulates two alternative specifications to test

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

(1) et = β0 + β1pdt + ut

(2) Δet = γ1Δpdt + vt

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

foreign price level, pd = p-p*, Δet = et - et-1 and Δpdt = pdt - pdt-1.

The “Absolute PPP” holds if β1 = 1 and ut is a white-noise process.

The “Relative PPP” holds if γ1 = 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 Δet = 0.95Δpdt

(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) 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?