Economics 423 Essay

Eddie Ng

ID# 977460

University of Calgary

Running Head: PPP & UIP Between US & Germany

PPP and UIP Between United States and Germany

Exchange of goods between various countries has dominated the international trade market today. To compensate the differences in the rate of inflation between two countries, appropriate exchange rate has to be implemented. Exchange rate is the price of one currency in terms of another. Exchange rates are among the most important prices in an open economy because of the strong influence on the current account and other macroeconomic variables (Krugman et al., 2000). One example of the macroeconomic variables is relative purchasing power parity (PPP). Another important macroeconomic variable, similar to purchasing power parity, is the uncovered interest parity (UIP). The empirical validity of purchasing power parity and uncovered interest parity will be examined via two countries, the United States and Germany. In Anker (1999), the idea that UIP puzzle was due to the consideration of the risk premia in relation to the change in exchange had been introduced by McCallum (1994). McCallum also suggested that the tradeoff between interest-rate and exchange rate stability produced an additional bias in the probability limit of the slope coefficient β in the UIP regression. Culver & Papell (1999) demonstrated statistically, using KPSS tests, that the combination of rejecting the stationary null hypothesis for nominal, but not for real, exchange rates constitutes evidence of long-run PPP. Finally, Engel (2000) argued that long-run PPP may not hold after all, since tests on long-run PPP tend to have serious size biases under many common statistical tests such as the Augmented Dickey-Fuller test (ADF), Error-Correlation Model (ECM), and the Horvath-Watson test (HW). There may be a significant result that is not detected by these tests. Moreover, many tests using the 25-year sample failed to reject the null that long-run PPP did not hold.

Theoretical Model

Purchasing power parity (PPP) is the theory of exchange currencies that are in equilibrium when the purchasing power is the same in each of the two countries. In other words, exchange rates move primarily as a result of differences in the change of price levels between countries in such a way as to keep the real exchange rate constant (Dornbusch et al., 1999). Another macroeconomic variable, similar to purchasing power parity, is called the uncovered interest parity (UIP). It is one of the fundamental theoretical building blocks for understanding the behavior of returns in international financial markets. If UIP holds, the return on a domestic currency deposit equals the expected return from converting the domestic currency into the foreign currency, investing it in a foreign deposit and then converting the proceeds back into the domestic currency at the future expected exchange rate (Huisman et al 1998).

Empirical Model

Since only the change in exchange rate is being studied here, the absolute PPP function, P = eP*, can be generalized into the relative PPP function by taking logarithms and differentiate with respect to time: In(P) = In(e) + In(P*). The formula for PPP becomes ( = (e + (*, which is equal to (e = ( - (* in general, where (e is the change in exchange rate, ( is the inflation rate and (* is foreign inflation rate. For UIP, the formula is defined as i = i* - x, where i is the domestic interest rate, i* is the foreign interest rate, and x is the expected growth in exchange rate. The variable x is being measured by assuming perfect foresight, and that the economic agents are able to accurately predict what exactly would happen in the future. Therefore, the x becomes the change in exchange rate, and the formula of UIP has been revised to (e = i - i*.

Estimation Procedure...