The aim of the essay is to statistically test the PPP Theory. The theory is tested on the monthly inflation and exchange rate data derived for two countries, Turkey and the USA, from the OECD database (OECD). A simplified statistical analysis is used on monthly inflation and exchange rate data for 10 years for both Turkey and the USA.
Before explaining the regression results, it must be illuminated that the rationale behind the PPP Theory is that the exchange rate adjustment is necessary to maintain a balance and/or parity in the purchasing power. If the purchasing powers are not similar, then consumers will be at liberty to shift their purchases wherever products are available cheaper. The essay tries to ascertain the purchasing power parity of Turkey vis-à-vis the USA. For this purpose, monthly historic inflation data has been extracted from 1990 January until December 2012 for both countries. The PPP theory suggests that the exchange rate of two countries equals the ratios of their price levels. In relative terms, the PPP theory can also be demonstrated, as the percentage change in the exchange rate of two countries is equal to the difference in the inflation rate of the two countries. Thus, in this case, the percentage change in the exchange rate of Turkish currency to the US dollar will equal the difference in the inflation of the two countries. In order to test this theory, the difference in the inflation rate of Turkey and the USA are regressed to the percentage change in their exchange rate.
Table 1 presents the results of the regression analysis. The regression equation that is derived from the regression analysis is:
Percentage change in exchange rate = 0.4133 + 0.0546 * (Inflation Turkey – Inflation USA)
The regression definitely demonstrates that there exists a purchasing power disparity in the two countries. Therefore, the PPP line is derived from the above equation where the slope is 0.054, which gives the regression coefficient. The intercept is 0.411. This indicates that if the inflation rate of both the countries is the same, then the exchange rate will change by a constant amount i.e. 0.411.
These two coefficients imply that in the case of Turkey and the USA, for any difference in the inflation rate, there is an equally offsetting percentage change in the exchange rate of the two countries. Clearly, if the inflation rate in Turkey rose higher than that in the USA, there will be a greater increase in the exchange rate of Turkey vis-à-vis the USA, devaluating its currency. Hence the regression shows that if country A experiences a higher inflation rate compared to country B, country A’s currency will be devalued, creating a gap in the PPP equilibrium, and hence, the PPP has to be adjusted.
Then observing the t-stat of the regression analysis it is found that there is a significant difference in the two values indicating that inflation and the exchange rate differ significantly, from what is stated in the PPP theory. However, the above analysis did not take into account the time lag in the analysis process.
The above analysis demonstrates that high inflation in Turkey has weakened the value of the country’s currency vis-à-vis the US dollar. This also is a sign of deviation in PPP in both the countries i.e. PPP is higher in the US. The data that has been taken is for a long period, yet deviations in PPP still exist. This analysis shows that using PPP theory to forecast exchange rates can be erroneous especially in presence of deviation in PPP between two countries.
OECD. OECD.StatExtracts. 2013. Web.