Economics Research: Regression Analysis
Abstract
This paper examines the effect of the inflation on the preservation of the exchange parity rate on two currencies during the period 1990-2016. The investigated currencies are British Pound and Japanese Yen against the base currency – US Dollar. The main objective of this paper is to illustrate whether correction of the nominal exchange rate on the inflation has an effect on the change of the exchange rate. Based on the presented results, we can make a conclusion that exchange rate follows a random walk pattern and has is not affected by the inflation differences between the observed countries. In order to create a holistic set of variables, which may have an effect on the exchange rate, additional variables have to considered – including the GDP growth, interbank rate, trade flows and FDI.
Introduction
In this paper we have investigated the relationship between the nominal exchange rate and the inflationary difference. The two currency pairs (GBPUSD and JPYUSD) have been tested for the stationary properties and we attempted to establish the relationship between the change in the inflation and its immediate effect on the exchange rate. The theory behind is based on the notion that if the inflation in one country were to rise, it would negatively affect the exchange rate and would cause currency devaluation. Academics state that if the inflation in one of the observed countries were to rise, then it would lower international interest in investments, deposits and credit, thus negatively affecting the exchange rate (MacDonald 1999). Although, throughout our paper, we have shown that this is not the case, at least one variable only cannot be the sole explanation of the exchange rate fluctuation.
Literature review
Based on the purchasing power parity (PPP) the nominal exchange rate should be equal to the PP of the two observed currencies at home and foreign countries respectively. Thus, the real exchange rate (RFX) should be constant and considered stationary in the long run. This implies that the shocks should have minor effects. The calculated real exchange rates should show the mean reverting properties. The nominal exchange rate regime should not have an impact on this property.
Despite the aforementioned theoretical background, the practical support does not support this notion. The unit root tests have, which were carried out on the observed currency pair have not rejected the null hypothesis of a random walk (Adler and Lehmann, 1983). Other academics, including support this notion (Rogoff, 1996). The comprehensive literature overview has revealed various approaches to overcome this deficit of the explanatory power. One of the suggested methodologies suggests to analyze the long time periods and break them in sub-periods. This would allow to take into account the regulatory changes, international crises (both economic and political) and show the effect of the PPP in the long-run to avoid short-term price stickiness effect (Taylor, 2002).
Additional control variables, which would have included interest rates, economic indicators and dummy variables for the political factors, have not been investigated in this analysis. Albeit, other academics have …
