5.6 Relationship of Exchange Rate with PPP and UIP

Comparing the association between the Exchange Rate and PPP revealed that deviation of the Price Differential between both counties around its mean is around 91% similar to the deviation of Exchange Rate around its mean. This Pearson correlation coefficient is significant at 1% (table 6). Looking at the graph for the comparison of the movement of change in Exchange Rate and Price Differential, there is very high similarity between their movements in late 2000’s, where it can be thought that they both are more interactive with each other.

In comparison of the Exchange Rate and UIP, the Pearson correlation analysis shows that the increase in the bond rate of Pakistan positively associated with change the Exchange Rate and increase in the bond rate of USA negatively change the exchange rate. And from figure 3 it can be seen that the peaks of this Interest rate Differential is matched by high change in the Exchange Rate. Now in the next chapter, the estimation will be done using these variables.

This section will take the preliminary analysis of relationship among variables discussed above and use it in the estimation platform. For the estimation process all the series must have similar order, higher the order more complex the method required to estimate the long run parameters. So following are the stationary tests that will check the order of the series.

5.7.1 Stationary Tests

5.7.1.1 Augmented Dickey Fuller Test (ADF)

This test builds on the prevous results and is based on a theory that if the stronger the ability of the past to explain present, closer will be the mean of the series to infinity, which will be statistically and emperically non-meaningful for the variables thats are discussed.

Consider the specificaiton form: Xt = aXt-1 + Dt — Higher the ability of the past more the a^ |1|, and more the value of Xt ^ ro. This property is called Unit Root.

AXt = (a-1)Xt-1 + Dt — (Dickey & Fuller, 1979) used this modification to the above unit root test so that it will be more dynamic and robust.

AXt = a0 + PXt_1 +Xt+ Dt — Where P = (a – 1)

**Table 6. Correlation analysis of exchange rate using PPP**

PriceLevel of Pakistan | Price Level ofUSA | PriceDifferential | ||

Exchange Rate of Pakistan | PearsonCorrelation | 0.942* | 0.944* | 0.908* |

Significance(2-tailed) | 0.000 | 0.000 | 0.000 | |

*correlation significant at 1% level | ||||

Self calculated using Spss 16 |

5.6 Relationship of Exchange Rate with PPP and UIP Comparing the association between the Exchange Rate and PPP revealed that deviation of the Price Differential between both counties around its mean is around 91% similar to the deviation of Exchange Rate around its mean. This Pearson correlation coefficient is significant at 1% (table 6). Looking at the graph for the comparison of the movement of change in Exchange Rate and Price Differential, there is very high similarity between their movements in late 2000’s, where it can be thought that they both are more interactive with each other. In comparison of the Exchange Rate and UIP, the Pearson correlation analysis shows that the increase in the bond rate of Pakistan positively