Financial Econometric Coursework
use STATA program as it mentioned in the paper and write about 400 words
According to the Purchasing Power Parity theory of nominal exchange rate determination, at time t a particular bundle of goods should cost exactly the same either:
(i) if it is purchased in the UK for a given price in £, say = £100; or
(ii) if it is purchased in the US from the proceeds of converting £100 into $ at the current nominal exchange rate.
If the purchase price in the US is = $150, PPP implies that the nominal exchange rate should be St = 1.5, i.e. £1 = $1.50.
An implication of PPP is that if price inflation is running at different rates in the two countries, the nominal exchange rate should adjust so that the PPP condition is maintained.
For example, suppose UK price inflation is 10% between year t and year t+1, and US price inflation is 5%.
In the UK, the bundle of goods will cost = £100×1.1 = £110
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