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Assume that the following regression model was applied to historical quarterly data: e t = a 0 + a 1 INT t + a 2

Assume that the following regression model was applied to historical quarterly data:

et = a0 + a1INTt + a2INFt + t

where et = percentage change in the exchange rate of the Japanese yen in period t

INTt = average real interest rate differential (U.S. interest rate - Japanese interest rate) over period t

INFt = inflation differential (U.S. inflation rate - Japanese inflation rate) in period t

a0, a1, a2 = regression coefficients

t = error term

Thus, the estimated regression equation is as follows:

^

et = 0.001 + 0.90 INTt + 0.80 INFt R2 = 0.85

(0.02) (0.30)

Please answer the questions below.

a. If the real interest rate differential was 2%, predict the change in the exchange rate. Which assumption are you making

b. If the inflation differential was 1%, predict the change in the exchange rate. Which assumption are you making?

c. If the real interest and inflation rate differentials were 1% and 2% respectively, predict the change in the exchange rate

d. What is the meaning of the R-squared?

e. Finally, determine which regression coefficients are statistically significant

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