Y5

Purchasing power parity hypothesis postulates that exchange rate growth (ER) in a country is positively related to domestic inflation rate () and negatively related to foreign inflation rate (*): ERtao+a + * + where u is a disturbance term. Under certain conditions, ER can be defined as a function of inflation differential D = - *. Some researchers often prefer to explain real exchange rate change which is defined as RER = ER - . Using a sample of 50 annual observations, a researcher estimates the following equations. (1) (2) (3) (4) ER = 0.10 +0.96 - 0.44*t (0.01) (0.24) (0.11) ER = 0.15 + 0.64D+ (0.03) (0.10) RER = 0.05 0.90 *t www R2=0.90, SSR = 900 R = 0.89, SSR = 901 SSR3 = 905 ER = b + bD + + 0.08*+ (0.02) (0.03) A Interpret Model 1. (0.24) B Compute the simple and partial correlation coefficients between ER, and in Model 1