inflation ,exchange rate & pridiction of forward rate

8/7/2019 Inflation ,Exchange Rate & Pridiction of FORWARD Rate

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Relationship between Inflation And Exchange Rate

1

A RESEARCH STUDY ON

TESTING OF RELATIONSHIP BETWEEN INFLATION

AND EXCHANGE RATE AND PREDICTION OF

FORWARD RATE

(An Analytic study on the Effect of Change in Inflation

To the Exchange Rate)

SUBMITTED TO BANGALORE UNIVERSITY IN PARTIAL FULFILLMENT OF THE

REQUIREMENTS OF THE MBA DEGREE COURSE

SUBMITTED BY

HARSHIT NEERAJ

06XQCM6028

Under the Guidance and Supervision of

Dr. NAGESH MALAVALLI

Principal MPBIM

2006-08

M.P. BIRLA INSTITUTE OF MANAGEMENT

Associate Bharatiya Vidya Bhavan

# 43, Race Course Road

Bangalore-560001


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M. P. Birla Institute of Management

ASSOCIATE BHARATIYA VIDYA BHAVAN

#43, RACE COURSE ROAD, BANGALORE -560001, INDIA

DECLARATION

I hereby declare that the project report titled Testing of the

relationship between Inflation and Exchange Rates and

Prediction of Forward Rateis a record of independent work carried

out by me, towards the partial fulfillment of the requirement for MBA

course of Bangalore University at M P Birla Institute of Management.

This has not been submitted in part or full towards any other degree

or diploma.

Bangalore Harshit Neeraj

Date - Reg. No. 06XQCM6028


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Dr. N.S. Malavalli

Certificate

This is to certify that the dissertation titled Testing of the

relationship between Inflation and Exchange Rates andPrediction of Forward Rate is an original study conducted by

Harshit Neeraj , bearing register number 06XQCM6028, of M. P.Birla

Institute of Management, Associate Bharatiya Vidya Bhavan, under

my guidance. This has not formed the basis for the award of any

Degree/Diploma by Bangalore University or any other University.

Bangalore

Date - (N.S. Malavalli)


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Dr. N. S. Malavalli

PRINCIPAL

Certificate

This is to certify that this report titled, Testing of the relationship

between Inflation and Exchange Rates and Prediction of

Forward Rate is the result of project work undertaken by Harshit

Neeraj, bearing the Register Number 06XQCM6028, under the

guidance of Dr. Nagesh Malavalli. This has not formed a basis for the

award of any Degree/Diploma for any University.

Bangalore

Date - (N. S. Malavalli)


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ACKNOWLEDGEMENT

Any successful work is always a product of many hands coming

together in co-operation and assistance. This work is no different. A

number of people are responsible for accomplishment of this work.

Their guidance and suggestions were highly helpful during the

course.

I express my deep sense of gratitude to DR. N. S. Malavalli, myproject guide and Principal , M. P. Birla Institute of Management

(MPBIM), Associate Bharatiya Vidya Bhavan, Bangalore, for his most

valuable guidance, inspiring supervision, periodical monitoring and

sparing his precious time in my internship.

I also express my sincere gratitude to my friends for all the

inspirations and giving me an opportunity to carry out the projectreport. Without their help, the project report would not have been

possible.

HARSHIT NEERAJ


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CONTENTS

Chapter I

INTRODUCTION

Chapter II

THEORETICAL BACKGROUND

Chapter III

LITERATURE REVIEW

Chapter IV

RESEARCH METHODOLOGY

Chapter V

DATA ANALYSIS

Chapter VI

CONCLUSIONS

BIBLIOGRAPHY


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Executive summary

The study, Testing of the relationship between Inflation and

Exchange Rates and Prediction of Forward Rate is done with an

intention to understand if there is any influence of Inflation on

Exchange Rates and to predict the future exchange rates. The study

has used the inflation rates data for the past 10 years of India, US,

UK and Austria and also the spot exchange rate of India with respect

of the above three countries.

The inflation rates were collected from www.inflatiodata.com and the

spot exchange rates for India were collected from www.rbi.org.in .

The period of 1998 2007 is considered for study purposes. The

data is collected; tabulated and annual percentages are calculated. In

addition to this other data like real GDP growth rates and trade deficit

data for India, US and UK is collected for the second part of the

research (For prediction of the forward rates for two years).

The Purchasing Power Parity formula does not hold good for the

forward rates the calculated values are somewhat deviating from the

real values as there are other factors also there which also effect the

exchange rates other than inflation rates. For testing the significance

of the values t- test was applied. So this part of study concludes that

there is a relationship between inflation rates and exchange rates andPPP holds true but not fully and there are some other factors also

there which affects exchange rates. And in the other part of the study

with the help of multiple regression future exchange rates for 2008

and 2009 is predicted.


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INTRODUCTION


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For decades the exchange rate was at the center of

macroeconomic policy debates in the emerging markets. In many

countries the nominal exchange rate was often used as a way of

bringing down inflation; in other countries mostly in Latin America the

exchange rate was used as a way of (implicitly) taxing the export

sector. Currency crises were common and were usually the result of

acute (real) exchange rate overvaluation. During the 1990s

academics and policy makers debated the merits of alternative

exchange rate regimes for the emerging economies. Based on

credibility-based theories many authors argued that developing and

transition countries should have hard peg regimes preferably

currency boards or dollarization. One of the main arguments for

favoring rigid exchange rate regimes was that emerging economies

exhibited a fear to float.

After the currency crashes of the late 1990s and early 2000,

however, a growing number of emerging economies moved awayfrom exchange rate rigidity and adopted a combination of flexible

exchange rates and inflation targeting. Because of this move the

exchange rate has become less central in economic policy debate in

most emerging markets. This, however, does not mean that the

exchange rate has disappeared from policy discussions. Indeed, with

the adoption of inflation targeting a number of important exchange

rate-related questions many of them new have emerged.

In this paper I address three broad policy issues related to

inflation targeting (IT) and exchange rates that have become

increasingly important in analyses on monetary policy in emerging


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countries. Aside from factors such as interest rates and inflation, the

exchange rate is one of the most important determinants of a

country's relative level of economic health. Exchange rates play avital role in a country's level of trade, which is critical to most every

free market economy in the world. For this reason, exchange rates

are among the most watched, analyzed and governmentally

manipulated economic measures. But exchange rates matter on a

smaller scale as well: they impact the real return of an investor's

portfolio. Here we look at some of the major forces behind exchange

rate movements.

OVERVIEW

Before we look at these forces, we should sketch out how exchange

rate movements affect a nation's trading relationships with other

nations. A higher currency makes a country's exports more expensiveand imports cheaper in foreign markets; a lower currency makes a

country's exports cheaper and its imports more expensive in foreign

markets. A higher exchange rate can be expected to lower the

country's balance of trade, while a lower exchange rate would

increase it.


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DETERMINANTS OF EXCHANGE RATES

Numerous factors determine exchange rates, and all are related to

the trading relationship between two countries. Remember, exchange

rates are relative, and are expressed as a comparison of

the currencies of two countries. The following are some of the

principal determinants of the exchange rate between two countries.

Note that these factors are in no particular order; like many aspects

of economics, the relative importance of these factors is subject to

much debate.

1. Differentials in inflation:

As a rule of thumb, a country with a consistently lower inflation rate

exhibits a rising currency value, as its purchasing power increases

relative to other currencies. During the last half of the twentieth

century, the countries with low inflation included Japan, Germanyand Switzerland, while the U.S. and Canada achieved low inflation

only later. Those countries with higher inflation typically see

depreciation in their currency in relation to the currencies of

their trading partners. This is also usually accompanied by higher

interest rates. (To learn more, see Cost-Push Inflation Versus

Demand-Pull Inflation.)

2. Differentials in interest rates:

Interest rates, inflation and exchange rates are all highly

correlated. By manipulating interest rates, central banks exert


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influence over both inflation and exchange rates, and changing

interest rates impact inflation and currency values. Higher interest

rates offer lenders in an economy a higher return relative to other

countries. Therefore, higher interest rates attract foreign capital

and cause the exchange rate to rise. The impact of higher interest

rates is mitigated, however, if inflation in the country is much

higher than in others, or if additional factors serve to drive the

currency down. The opposite relationship exists for decreasing

interest rates - that is, lower interest rates tend to decrease

exchange rates. (For further reading, see What Is Fiscal Policy?)

3. Current-account deficits:

The current account is the balance of trade between a country and

its trading partners (see Understanding The Current Account In

The Balance Of Payments), reflecting all payments between

countries for goods, services, interest and dividends. A deficit in

the current account shows the country is spending more on foreign

trade than it is earning, and that it is borrowing capital from foreign

sources to make up the deficit. In other words, the country requires

more foreign currency than it receives through sales of exports,

and it supplies more of its own currency than foreigners demand

for its products. The excess demand for foreign currency lowers

the country's exchange rate until domestic goods and services are

cheap enough for foreigners, and foreign assets are too expensive

to generate sales for domestic interests.


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4. Public debt:

Countries will engage in large-scale deficit financing to pay for

public sector projects and governmental funding. While such

activity stimulates the domestic economy, nations with large public

deficits and debts are less attractive to foreign investors. The

reason? A large debt encourages inflation, and if inflation is high,

the debt will be serviced and ultimately paid off with cheaper real

dollars in the future. In the worst case scenario, a government may

print money to pay part of a large debt, but increasing the money

supply inevitably causes inflation. Moreover, if a government is not

able to service its deficit through domestic means (selling domestic

bonds, increasing the money supply), then it must increase the

supply of securities for sale to foreigners, thereby lowering their

prices. Finally, a large debt may prove worrisome to foreigners if

they believe the country risks defaulting on its obligations.

Foreigners will be less willing to own securities denominated in

that currency if the risk of default is great. For this reason, the

country's debt rating (as determined by Moody's or Standard &

Poor's, for example) is a crucial determinant of its exchange rate.

5. Terms of trade:

A ratio comparing export prices to import prices, the terms of tradeis related to current accounts and the balance of payments. If the

price of a country's exports rises by a greater rate than that of its

imports, its terms of trade have favorably improved. Increasing

terms of trade shows greater demand for the country's exports.


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This, in turn, results in rising revenues from exports, which

provides increased demand for the country's currency (and an

increase in the currency's value). If the price of exports rises by asmaller rate than that of its imports, the currency's value will

decrease in relation to its trading partners.

6. Political stabilityand economic performance:

Foreign investors inevitably seek out stable countries with strong

economic performance in which to invest their capital. A country

with such positive attributes will draw investment funds away from

other countries perceived to have more political and economic risk.

Political turmoil, for example, can cause a loss of confidence in a

currency and a movement of capital to the currencies of more

stable countries.


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THEORETICALBACKGROUND


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PURCHASING POWER PARITY THEORY

The purchasing power parity (PPP) theory uses the long-term

equilibrium exchange rate of two currencies to equalize their

purchasing power. Developed by Gustav Cassel in 1920, it is based

on the law of one price: the theory that, in an ideally efficient market,

identical goods should have only one price.

A purchasing power parity exchange rate equalizes the

purchasing power of different currencies in their home countries for a

given basket of goods. It is often used to compare the standards of

living between countries, rather than a per-capita gross domestic

products comparison at market exchange rates. The best known and

most used purchasing power parity exchange rate is the Geary-

Khamis dollar, also referred to as the international dollar.

PPP exchange rates (the "Real Exchange Rate") fluctuations

are mostly due to market exchange rates movements. Aside from this

volatility, consistent deviations of the market and PPP exchange rates

are observed, for example (market exchange rate) prices of non-

traded goods and services are usually lower where incomes are

lower. (A U.S. dollar exchanged and spent in India will buy more

haircuts than a dollar spent in the United States). PPP takes into

account this lower cost of living and adjusts for it as though all incomewas spent locally. In other words, PPP is the amount of a certain

basket of basic goods which can be bought in the given country with

the money it produces.


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There can be marked differences between PPP and market

exchange rates. [1] For example, the World Bank's World

Development Indicators 2005 estimated that in 2003, one United

States dollar was equivalent to about 1.8 Chinese yuan by

purchasing power parity [2] much different than the nominal

exchange rate that put one dollar equal to 7.6 yuan. This discrepancy

has large implications; for instance, GDP per capita in the People's

Republic of China is about US$1,800 while on a PPP basis it is about

US$7,204. This is frequently used to assert that China is the world's

second-largest economy, but such a calculation would only be valid

under the PPP theory. At the other extreme, Japan's nominal GDP

per capita is around US$37,600, but its PPP figure is only

US$30,615.

RELATIVE PPP-

Purchasing power parity is often called absolute purchasing

power parity to distinguish it from a related theory relative purchasing

power parity, which predicts the relationship between the two

countries' relative inflation rates and the change in the exchange rate

of their currencies.

Relative PPP relates the inflation rate (the change of price

levels) in each country to the change in the market exchange rate,

where St is the spot rate in Foreign Currency/Domestic Currency and

Pt is the price level in period t (foreign values are marked by an

asterisk). This relation is necessary but not sufficient for absolute

purchasing power parity.


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According to this theory, the change in the exchange rate is

determined by price level changes in both countries. For example, if

prices in the United States rise by 3% and prices in the European

Union rise by 1% the purchasing power of the USD should depreciate

by 2% compared to the purchasing power of the EUR (equivalently

the EUR will appreciate by about 2%)

EXCHANGE RATES EFFECTS-

For many years economists have been concerned with theeffectiveness of nominal exchange rate changes as shock absorbers.

This issue has been related with the traditional rejection of

structuralists to devaluations, and with the historical skepticism

regarding the benefits of flexible exchange rates. From a policy point

of view this issue can be decomposed in three questions: (a) what

are the effects of nominal exchange rate changes on the real

exchange rate? (b) What are the effects of real exchange rate

changes on the external position of a country? And (c) what are the

collateral effects of nominal exchange rate changes on balance

sheets and aggregate economic activity. In this section I deal with

the first issue the effects of nominal exchange rate changes on real

exchange rates in inflation targeting regimes. This question is

directly related to the issue of the pass-through from exchange rates

to domestic prices, an issue that have been discussed in great detail

in the last few years. Much of the recent literature on pass-through,

however, has ignored this exchange rate effectiveness question,

and has focused on the inflationary effects of exchange rate changes.


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If the inflationary effects of exchange rate changes are large,

the authorities will have to implement monetary and fiscal policies

that offset the inflationary consequences of exchange rate changes.

Historically, pass-through has tended to be large in emerging

countries and, in particular, in countries that experience a currency

crises. Borensztein and De Gregorio (1999), for example, used a 41

countries sample and found that after one year 30% of a nominal

devaluation has been passed through to inflation; after two years the

pass-through was a very high 60% on average. They also found that

the degree of pass-through was significantly smaller in advancedcountries. A number of recent papers have shown that the degree

of pass-through has declined substantially since the 1990s;

particularly telling examples are the UK and Sweden after their

currency crises in the early 1990s, and Brazil after the 1999

devaluation of the real. In an influential paper Taylor (2000) has

argued that this lower pass-through has been the result of a decline

in the level and volatility of inflation.

INFLATION

The overall general upward price movement of goods and

services in an economy, usually as measured by the Consumer Price

Index and the Producer Price Index. Over time, as the cost of goods

and services increase, the value of a dollar is going to fall because a

person won't be able to purchase as much with that dollar as he/she

previously could. While the annual rate of inflation has fluctuated


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greatly over the last half century, ranging from nearly zero inflation to

23% inflation, the Fed actively tries to maintain a specific rate of

inflation, which is usually 2-3% but can vary depending on

circumstances. opposite of deflation.

RATE OF INFLATION-

As we said earlier, the prices of everything goes up over time

and this phenomenon is called inflation. The question is: By how

much do the prices go up? At what rate do the prices do up?

The rate at which the prices of everything go up is called the

"rate of inflation". For example, if the price of something is Rs.100 this

year and next year the price becomes approximately Rs.104 then the

rate of inflation is 4%. If the price of something is Rs.80 then after a

year with a rate of inflation of 4% the price go up to (80 x 1.04) = 83.2

So, when you make an investment, make sure that your rate of

return on the investment is higher than the rate of inflation in your

country. In our county India, for the year 2005-2006 the rate of

inflation was 4% (Which is really low and amazing!). This rate keeps

changing every year. The finance minister generally gives the official

statement on the inflation rate of the country for a particular year.


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EFFECT OF INFLATION-

The effect of inflation is the prices of everything going up over

the years. A movie ticket was for a few paise in my dads time. Now it

is worth Rs.50. My dads first salary for the month was Rs.400 and

over he years it has now become Rs.75,000. This is what inflation is,

the price of everything goes up. Because the price goes up, the

salaries go up.

If you really thing about it, inflation makes the worth of money

reduce. What you could buy in my dads time for Rs.10, now a days

you will not be able to buy for Rs.400 also. The worth of money has

reduced! If this is still not clear consider this, when my father was a

kid, he used to get 50paise pocket money. He used to use this money

to go and watch a movie (At that time you could watch a movie for

50paise!)

Now, just for the sake of understanding assume that my dad

decided in his childhood to save 50paise thinking, that one day when

he becomes big, he will go for a movie. Many years pass. The year

now is 2006. My dad goes to the theater and asks for a ticket. He

offers the ticket-booth-guy at the theater 50paise and asks for a

ticket. The ticket booth guy says, I am sorry sir, the ticket is worth

Rs.50. You will not be able to even buy a paan with the 50paise!!

The moral of the story is that, the worth of the 50paise reduced

dramatically. 50paise could buy a whole lot when my dad was a kid.


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Now, 50paise can buy nothing. This is inflation. This tells us two

important things.

Firstly: Do not keep your money stagnant. If you just save

money by putting it your safe it will loose value over time. If you have

Rs.1000 in your safe today and you keep it there for 10years or so, it

will be worth a lot less after 10 years. If you can buy something for

Rs.1000 today, you will probably require Rs.1500 to buy it 10 years

from now. So do not keep money locked up in your safe.

ALWAYS INVEST MONEY.

If you cant think where to invest your money, then put it in a

bank. Let it grow by gaining interest. But whatever you do, do not just

lock your money up in your safe and keep it stagnant. If you do this,

you will be loosing money without even knowing it. The more money

you keep stagnant the more money you will be loosing.

Secondly: When investing, you have to make sure that the rate

of return on your investment is higher than the rate of inflation.

INFLATIONARY EXPECTATIONS

Most economies generally exhibit inflation, meaning a given

amount of money buys fewer goods in the future than it will now. The

borrower needs to compensate the lender for this. According to the

theory of rational expectations, people form an expectation of what

will happen to inflation in the future. They then ensure that they offer


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or ask a nominal interest rate that means they have the appropriate

real interest rate on their investment.

MONEY AND INFLATION:

Loans, bonds, and shares have some of the characteristics of

money and are included in the broad money supply. By setting the

nominal interest rate on a short-term risk-free liquid bond (such as

Govt Treasury Bills). The Government institution can affect the

markets to alter the total of loans, bonds and shares issued.

Generally speaking, a higher real interest rate reduces the broad

money supply. Through the quantity theory of money, increases in

the money supply lead to inflation. This means that interest rates can

affect inflation in the future.

The other factors that influence the interest rates are

1. Deferred consumption

2. Alternative investments

INTEREST RATE

An interest rate is the price a borrower pays for the use of

money he does not own, and the return a lender receives for

deferring his consumption, by lending to the borrower. Interest rates

are normally expressed as a percentage over the period of one yearon the principle amount or capital employed.


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NOMINAL INTEREST RATE

It is the amount, in money terms, of interest payable. For

example, suppose A deposits Rs100 with a bank for 1 year and they

receive interest of Rs10. At the end of the year their balance is

Rs110. In this case, the nominal interest rate is 10% per annum.

REAL INTEREST RATE

The real interest rate is the nominal interest rate minus the

inflation rate. It is a measure of cost to the borrower because it takes

into account the fact that the value of money changes due to inflation

over the course of the loan period. Except for loans of a very short

duration, the inflation rate will not be known in advance. People often

base their expectation of future inflation on an average of inflation

rates in the past, but this gives rise to errors. The real interest rate

after the fact may turn out to be quite different from the real interest

rate that was expected in advance. Conversely, when inflation was on

a downward trend in most countries, lenders fared well, while

borrowers ended up paying much higher real borrowing costs than

they had expected.

The complexity increases for bonds issued for a long term,

where the average inflation rate over the term of the loan may be

subject to a great deal of uncertainty. In response to this, many

governments have issued real return (also known as inflation indexed

bonds), in which the principle value rises each year with the rate of

inflation, with the result that the interest rate on the bond is a real

interest rate.


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Interest rates are set by a government institution, usually a

central bank, as the main tool of monetary policy. The institution

offers to buy or sell money at the desired rate and, because of their

immense size, they are able to effectively set the nominal interest

rate on a short-term risk-free liquid bond (such as Govt Treasury

Bills).


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LITERATURE

REVIEW


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Does appreciation of currency offsets inflation differential?

(Young Seok Ahn, Korea Development Institute)

This study focuses on the effects of inflation and exchange rate

policy on direct investment flows to developing countries. They find

that inflation does have a substantial negative effect on capital

inflows. Their estimates indicate that this effect can be significantly

reduced, but not eliminated, by following exchange rate policies

which avoid substantial overvaluation of the currency.

Does Exchange Rate affect inflation, exports, imports andeconomic activity?

(Sebastian Edwards, National Bureau Of Economic Research)

This paper deals with the relationship between inflation

targeting and exchange rates. They address three specific issues:

first, they analyze the effectiveness of nominal exchange rates as

shock absorbers in countries with inflation targeting. This issue is

closely related to the magnitude of the " pass-through" coefficient.

Second, they investigate whether exchange rate volatility is different

in countries with an inflation targeting regime than in countries with

alternative monetary policy arrangements. And third, they discuss

whether the exchange rate should play a role in determining the

monetary policy stance under inflation targeting. An alternative way ofposing this question is whether the exchange rate should have an

independent role in an open economy Taylor rule.


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Is relative PPP a true measure in long run?

(Purchasing Power Parity in the Long Run, by Niso Abuaf and Philippe

Jorion)The Journal of Finance, Vol. 45, No. 1 (Mar., 1990), pp. 157-174

This paper re-examines the evidence on Purchasing Power

Parity (PPP) in the long run. Previous studies have generally been

unable to reject the hypothesis that the real exchange rate follows a

random walk. If true, this implies that PPP does not hold. In contrast,

this paper casts serious doubt on this random walk hypothesis. The

results follow from more powerful estimation techniques, applied in a

multilateral framework. Deviations from PPP, while substantial in the

short run, appear to take about three years to be reduced in half.

Does the PPP and relative PPP holds good in Europeancountries?(Antnio Portugal Duarte Faculty of Economics - University of Coimbra and

Group for Monetary and Financial Studies)

This study apply Purchasing Power Parity (PPP) theory to the

analysis of long-run equilibrium in the foreign exchange market. They

study the case of Portugal vis--vis Germany and Spain, and the

case of Spain vis--vis Germany, in the period 1960-1990. The

empirical analysis was based on unit-root testing (using ADF tests)

and Johansens methodology for the study of co-integration. Theyworked with linear long-run relationships based exclusively on PPP,

as well as with long-run relations that also allowed for the effect of

interest rates. In a situation in which PPP does not hold, one could

think that on account of some natural reason agents believe that, as


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time goes by, the dominant currency, which is also the reference

currency of the EMS (the German Mark), will appreciate. They

concluded, on the contrary, that the weaker currencies were the ones

that with the passing of time appreciated in real terms. The fact that

PPP theory was applied to two southern European countries

deserves a special mention, because it may serve as an example for

other countries that come to be in a position similar to that of Portugal

and Spain before their adhered to the European Union.


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RESEARCH

METHODOLOGY


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RESEARCH BACKGROUND-

Relative PPP is a very considerable approach when we talk of

inflation rate and exchange rate relationship. Many financial

controversies and literature have surrounded this relationship for

various countries of the world. But in Indian context very less studies

have been done in this regard. This study will cover the long run as

well as short run relationship between the above two measures. It is

already proved that short run relationship does not have significant

relationship and PPP and relative PPP holds true in case of long run

basis. Basically this study is all about any change in the expected

differential rate of inflation tends to be offset over a long run by an

equal but opposite change in spot exchange rate.

PROBLEM STATEMENT-

This paper studies the effect of inflation on exchange rate in

India with respect to U.S.,U.K. & Austria and also predicts the forward

exchange rates.

OBJECTIVE-

To check the relationship between inflation rate and exchange

rate with the help of relative purchasing power parity and check the

significance of the model.


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LIMITATIONS-

The study is limited to the period of 10 years due to non

availability of resources.

DATA SOURCE-

The study has been carried out on the basis of secondary data

collected from Reserve Bank of India (RBI). The inflation rates have

been taken from website of inflation rate of both India and US. Spot

rates are taken from website of historical data.

RESEARCH TOOL-

The research tools that have been used in the study are t-test

simple and multiple regression and purchasing power parity models:

1. Relative purchasing power parity model-

Relative PPP tells us about the relation between the exchange

rate and the percentage changes in the prices at home and

abroad, rather than absolute price levels Relative PPP may hold

rather well in the short run when inflation is high.. At least in the

short run, there definitely is real exchange risk. Moreover, the

conventional claim that PPP holds in the long run merely means

that the variance of PPP-deviations increases less than

proportionally with time.

(Ia Ib) / (1 + Ib) = (Fo So) / So


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In the above equation Ia an Ib are the inflation rates for the home

country and foreign country and Fo is one year forward rate and

So is the spot rate fot the home country.

RELATIVE PPP AS A THEORY OF EXCHANGE RATES:

Takes the inflation rates as determined by some outside factors

(like the money supply and the level of economic activity).

Says that the exchange rate between two countries must

change to reflect differences in inflation rates between these

countries.

THE LINKS BETWEEN RELATIVE PPP, ABSOLUTE PPP

If absolute PPP holds, then so will relative PPP.

Relative PPP may hold even if there are persistent deviations in the

average absolute price levels across countries.

2. PAIRED T- TEST

A t-test is any statistical hypothesis test in which the test statistic

has a Student's t distribution if the null hypothesis is true. It is applied

when sample sizes are small enough that using an assumption ofnormality. This function gives a paired Student t test, confidence

intervals for the difference between a pair of means and, optionally,

limits of agreement for a pair of samples.


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The paired t test provides an hypothesis test of the difference

between population means for a pair of random samples whose

differences are approximately normally distributed. Please note that a

pair of samples, each of which are not from normal a distribution, often

yields differences that are normally distributed.

The test statistic is calculated as:

where d bar is the mean difference, s is the sample variance, n is the

sample size and t is a Student t quantile with n-1 degrees of freedom.

Power is calculated as the power achieved with the given

sample size and variance for detecting the observed mean difference

with a two-sided type I error probability of (100-CI%)%.

LIMITS OF AGREEMENT

If the main purpose in studying a pair of samples is to see how

closely the samples agree, rather than looking for evidence of

difference, then limits of agreement are useful. Stats Direct displays

these limits with an agreement plot if you check the agreement boxbefore a paired t test runs. For more detailed analysis of this type.


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3. MULTIPLE REGRESSION

The purpose of multiple regression is to predict a single variable

from one or more independent variables. Multiple regression withmany predictor variables is an extension of linear regression with two

predictor variables. A linear transformation of the X variables is done

so that the sum of squared deviations of the observed and predicted

Y is a minimum. The computations are more complex, however,

because the interrelationships among all the variables must be taken

into account in the weights assigned to the variables. The

interpretation of the results of a multiple regression analysis is also

more complex for much the same reason.

The prediction of Y is accomplished by the following equation:

Y'i = b0 + b1X1i + b2X2i + + bkXki

The "b" values are called regression weights and are computed in away that minimizes the sum of squared deviations

in the same manner as in simple linear regression. In this case there

are K predictor variables rather than two and K + 1 regression

weights must be estimated, one for each of the K predictor variable

and one for the constant (b0) term.


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36

DATA

ANALYSIS


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DATA

INFLATION RATE

Data for India, US, UK & Austria are taken for the period of 10 yearsfrom 1998 to 2007.

IndiaAnnual Inflation Rates

Year Rates1998 13.13

1999 4.692000 4.012001 3.852002 4.152003 3.982004 3.632005 4.282006 6.162007 5.66

US

Annual Inflation Rates

Year Rates

1998 1.55

1999 4.69

2000 4.01

2001 3.85

2002 4.15

2003 3.98

2004 3.63

2005 4.28

2006 6.16

2007 5.66


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UK


Year Rates1998 1.61

1999 1.34

2000 0.8

2001 1.21

2002 1.33

2003 1.42

2004 1.34

2005 2.112006 2.3

2007 2.34

Austria


Year Rates1998 0.9

1999 0.6

2000 2.3

2001 2.7

2002 1.8

2003 1.3

2004 2.1

2005 2.3

2006 1.5

2007 2.2


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39

SPOT EXCHANGE RATE-

The average spot exchange rates for India with respect to US, UK &

Austria are given below for the period of 10 years from 1998 to 2007.

With US

Spot exchange rates(in INR)

Year Rates

1998 42.291999 42.44

2000 43.62

2001 46.64

2002 48.8

2003 47.41

2004 43.77

2005 43.76

2006 44.612007 43.13


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With Austria

Spot exchange rates (in INR)

Year Rates

1998 44.23

1999 45.65

2000 41.5

2001 41.18

2002 42.9

2003 51.09

2004 53.96

2005 53.37

2006 53.77

2007 57.64

With UK

Spot exchange rates(in INR)

Year Rates

1998 71.83

1999 68.042000 69.28

2001 66.25

2002 70.15

2003 74.33

2004 80.96

2005 82.11

2006 77.12

2007 85.35


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41

Calculated forward rates in Spread sheets for each year on the basis

of Relative PPP of India with respect to US, UK, Austria respectively.

With US

Year Actual Calculated

1999 42.44 47.112434

2000 43.62 43.478262

2001 46.64 43.885821

2002 48.80 47.102635

2003 47.41 50.029727

2004 43.77 48.202716

2005 43.76 44.174962

2006 44.61 44.136694

2007 43.13 45.871732

2008 41.23 44.308369

With UK


1999 68.04 79.973702

2000 69.28 70.289201

2001 66.25 71.486238

2002 70.15 67.978090

2003 74.33 72.102265

2004 80.96 76.206206

2005 82.11 82.789469

2006 77.12 83.854968

2007 85.35 80.029904

2008 82.48 88.118829


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42

With Austria


1999 42.44 49.5910792000 43.62 47.505949

2001 46.64 42.193695

2002 48.80 41.641120

2003 47.41 43.890324

2004 43.77 52.441641

2005 43.76 54.768607

2006 44.61 54.4029682007 43.13 56.238652

2008 41.23 59.591413

T- Test application

Applying t- test to check the means are significantly different from

zero or not or in other words to check how much the Calculated

values are near to the Real values

HYPOTHESIS:

H0: There is no significance difference between the

means.

H1: There is significance difference between the means.


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Results of t-test done in excel sheets are given below

For India and US

t-Test: Paired Two Sample for Means

Variable 1 Variable 2Mean 51.58048699 44.541

Variance 7.507107403 5.577921111

Observations 10 10

Pearson Correlation -0.405032441

Hypothesized Mean Difference 0

Df 9t Stat 5.199907964

P(T


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For India and UK


Variable 1 Variable 2

Mean 93.87349689 75.607

Variance 64.61817518 47.96115667

Observations 10 10

Pearson Correlation 0.869962331


Df 9

t Stat 14.57012679

P(T


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For India and Austria


Variable 1 Variable 2

Mean 56.8981114 49.64

Variance 19.805193 38.6004

Observations 10 10

Pearson Correlation 0.846582282


Df 9

t Stat 6.741708385

P(T


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46

Applying multiple regression approach to calculate forward exchange

rate from 2007 onwards for US and UK. Here considering other

independent factors that affects exchange rates like GDP and Trade

deficit differentials other than Inflation rate differential.

WITHUS

Year

SpotExchange

Rate Inflation Diff.Trade deficit

Rate GDP Rate.

1998 42.29 1.1140325 1.033677419 1.0052656

1999 42.44 1.02446423 0.946895693 1.0134486

2000 43.62 1.00609402 0.378365867 1.0095238

2001 46.64 1.00991928 1.252291411 1.0220388

2002 48.8 1.02519933 1.090610637 1.0171640

2003 47.41 1.01672045 1.410872314 1.0523763

2004 43.77 1.00925205 1.532249019 1.0172413

2005 43.76 1.00860818 1.188116287 1.0503876

2006 44.61 1.02828361 1.348278471 1.05609284

2007 43.13 1.02732134 1.455889553 1.0621963


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Regression Analysis (US)

Regression Statistics

Multiple R 0.422054133

R Square 0.178129691Adjusted R Square -0.23280546

Standard Error 2.460389101

Observations 10

REGRESSION LINE-(India with US)

Y = 107.61 29.33X1 + 0.237X2 31.06 X3

CoefficientsStandard

Error t Stat P-value Lower 95%Upper95%

Lower95.0%

Upper95.0%

Intercept 107.6088625 64.56404 1.6667 0.146623 -50.3737 265.5914

-

50.3737 265.59

X Variable 1 -29.332373 28.31228 -1.03603 0.340127 -98.61 39.94527 -98.61 39.945

X Variable 2 0.236918784 2.40275 0.098603 0.924665 -5.6424 6.116235 -5.6424 6.1162

X Variable 3 -31.06297 46.98958 -0.66106 0.53312 -146.042 83.91638

-

146.042 83.916

RESIDUAL OUTPUT

Observation Predicted Y Residuals

1 42.69511857 -0.40512

2 45.12964394 -2.68964

3 45.28717415 -1.66717

4 45.59953331 1.040467

5 45.4141211 3.385879

6 44.45287861 2.957121

7 45.46931441 -1.69931

8 44.68287299 -0.92287

9 43.86380487 0.746195

10 43.87553805 -0.74554


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WITH UK

Year

Spot

exchangerate

InflationDiff.

Trade deficitRate. GDP Rate.

1998 71.83 1.113375 1.6022 1.05

1999 68.04 1.033057 1.4443 1.055

2000 69.28 1.031845 0.4904 1.06

2001 66.25 1.026084 1.3253 1.0527

2002 70.15 1.02783 1.1627 1.043

2003 74.33 1.025242 1.5624 1.085

2004 80.96 1.022597 1.9124 1.062

2005 82.11 1.021252 1.3977 1.084

2006 77.12 1.037732 1.4254 1.092

2007 85.35 1.032441 1.4869 1.093


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49

Regression Analysis (UK)

Regression Statistics

Multiple R 0.802719

R Square 0.644358Adjusted RSquare 0.466537

Standard Error 4.791535

Observations 10

Coefficients

Standard

Error t Stat P-va lue

Lower

95%

Upper

95%

Lower

95.0%

Uppe

95.0%

ntercept -174.59 132.5674 -1.31699 0.235903 -498.971 149.7907 -498.971 149.7

X

Variable

-6.5371 62.74885 -0.10418 0.920423 -160.078 147.0038 -160.078 147.0

X

Variable

2 5.740435 4.527319 1.267955 0.251793 -5.33752 16.81839 -5.33752 16.81

X

Variable

3 232.2671 91.64992 2.534286 0.044422 8.007804 456.5264 8.007804 456.5

RESIDUAL OUTPUT

Observation Predicted Y Residuals

1 71.20948 0.6205212 71.98944 -3.949443 67.6829 1.5970994 70.8177 -4.56775 67.6199 2.530097

6 79.68649 -5.356497 76.37079 4.5892128 78.53486 3.5751419 80.44427 -3.3242710 81.06416 4.285836


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REGRESSION LINE-(India with UK)

Y = -174.59 6.54X1 + 5.74X2 + 232.27X3

Value of X1, X2, X3 for both the equation on the basis of trend

forecasting for the years 2008 and 2009 are given below-

With US

2008 2009

X1 1.0231 1.0257

X2 1.5172 1.621

X3 1.097 1.101

With UK

2008 2009

X1 1.045 1.051

X2 1.5172 1.621

X3 1.097 1.101

And on the basis of values of above variables the forecasted forward

exchange rates are as-

Forward Rate With US With UK

2008 43.88299 82.08507

2009 43.70636 83.57077


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CONCLUSION


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This paper has attempted to study the existence of relationship

between Exchange rates and Inflation. This study is limited to a

period of 10 years due to non availability of data. The data that was

collected has been processed with the help of Purchasing Power

Parity Model that defines the relationship between inflation and

exchange rates to calculate the forward rate. The stationarity was

tested using the T-test which revealed that the significance difference

between the mean is not equal to zero for the period of study i.e. from

1998-2007. And thus null hypothesis is rejected in all the case. This

shows that exchange rates are not only influenced by the inflation

rates but there are other factors also like GDP growth rates, interest

rates, public debt, trade deficit, political influences etc. which affect

the exchange rate. In second part of the project the forecasting of the

forward rates has been done with the help of multiple regression

analysis, in this approach with inflation rate some of other factors like

Real GDP growth rates and Balance of Payments has been taken

into consideration and thus with the help of above factors the next

two years forward rates has been forecasted.


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References and

bibliography


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References-

1. Abuaf, Niso & Jorion, Philippe, 1990. " Purchasing Power Parity

in the Long Run," Journal of Finance, American Finance

Association, vol. 45(1), pages 157-74, March.

2. Relative PPP in medium run Journal of International Money

and Finance, Volume 13, Issue 5, October 1994, Pages 602-622

Prakash Apte, Marian Kane, Piet Sercu.

3. Sarno, L. and Taylor, M. P. (2002). Purchasing power parity and

the real exchange rate, International Monetary Fund Staff Papers,

49, pp. 65105.

4. "A multi-country comparison of the linkages between inflationand exchange rate competitiveness" International Journal of

Finance & Economics, John Wiley.

5. GeoffreyBooth, James E.Duggan,Peter E.Koveos. (1985)

Deviations from purchasing power parity, relative inflation, and

exchange rates: the recent experience. The Financial Review

20:2, 195-218


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Bibliography

TEXT BOOKS

Multinational Business Financeby David K Eiteman,Arthur K Stonehill and Michael H Moffett.

Basic Econometricsby Damodhar Gujarathi.

WEBSITES

www.google.com

www.finance.yahoo.com

www.rbi.org.in

www.inflationdata.com

www.thisismoney.co.uk

www.indiastat.com

www.cia.gov

www.indiabudget.nic.in

www.statistics.gov.uk

www.fxwords.com


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