# We want to understand whether the Purchasing Parity holds

Goal of the assignment: we want to understand whether the Purchasing Parity holds. If it does, we can use it to predict future exchange rates. You need to prepare a research report.

## We want to understand whether the Purchasing Parity holds

Policy: The assignment is DIFFICULT. Expect to spend 10-15 hours working on it. A well-written and executed assignment can add up to 4% to the overall score. You can work in groups of 2 students. You cannot ask Svetla for help!!! Deadline: last day of class. The usual rules about academic integrity apply!

Goal of the assignment: we want to understand whether the Purchasing Parity holds. If it does, we can use it to predict future exchange rates. You need to prepare a research report.

[1] Background reading: Predicting Exchange Rates Is Hard. Could Dusting Off an Old Technique Help?
https://insight.kellogg.northwestern.edu/article/exchange-rates-predictions-real-nominal

### You can read the whole paper here:

https://www.kellogg.northwestern.edu/faculty/rebelo/htm/RER.pdf

[2] The goal of this assignment is to work on forecasting the exchange rate. Choose your country carefully!!! (before you choose the country, read [1]). Some good possible choices: Australia, Canada, New Zealand, Sweden, the UK, Brazil, Chile, Colombia, Israel, Mexico, Norway, Peru, Philippines, South Africa, South Korea, Thailand, Turkey. If you are really interested in other currencies or exchange rates, make sure you have enough data.

[3] Data: you need annual data on the exchange rate, inflation in the U.S, and the inflation of the country of your choice, from now on, country A. (look at FRED, the World Bank, the OECD, BIS, Bloomberg). Describe where you got the data. Plot the annual exchange rate over time. Plot the annual inflation rates over time.

#### [4] Describe the monetary policy and recent economic history of the country.

Also, How does the Central Bank conduct its policy? Additionally,  Does it intervene in the foreign exchange market, any recent financial crises? Further, Other disruptions in the currency market? Lastly, Should you exclude one or more observations on this basis?

[5] Plot the annual exchange rate changes AGAINST the differential inflation rates between country A and the U.S. for the last 25-30 years. Interpret. How do your results match up to the Relative PPP theory?

[6] Plot the 3-year and 5-year exchange rate changes AGAINST the differential 3-year and 5-year inflation rates between country A and the U.S. for the last 25-30 years. Compare the results to your findings in [5].

[7] Additionally, Regress the annual exchange rate changes on the annual inflation rate differential. Also, Estimate the intercept and the slope coefficients. Lastly, Interpret the regression results.

[8] Repeat the regression analysis by omitting the last 3 years of data. Predict the exchange rate using your regression model. How far are your estimates from the actual exchange rate over the last 3 years? Also, What to submit: excel spreadsheet with your data, graphs, and regression results. A printed and stapled write-up. The last day you can submit your work is the last day of class.

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