This project will answer the above question by identifying if the prices of the same basket of products in UK and Bulgaria are equal when measured in a common currency using the absolute form of PPP (Purchasing Power Parity). Ultimately, it will be possible to assume if there is any market imperfection therefore it will be necessary to reject hypothesis of absolute form and accept relative form of PPP.
It will examine what, how and why inflation rates and interest rates have a major impact on exchange rates and therefore can influence the intensity of investment in a given country. In order to understand influence of the investment it is necessary to recognise the relationship and extensity between exchange rates, interest rates and inflation.
The analyses will investigate the change of the exchange rates between those two countries based on the statistical tests of PPP theory. The Minitab test will help to perform the regressions through quarter period. The test will establish the difference regarding to the information and exchange rates, as a result the effect of the future investment of those countries will be known.
PPP theory is necessary to use since bases its predictions of exchange rate movement on changing patterns of trade due to different inflation rates between countries (Fox 2007). Consequently, the absolute form of PPP must be denied for the reason of that it cannot be implemented in real life.
Section 2. Test design
The theory of PPP is being tested with a comparison of the exchange rate and inflation rate between UK (pound) and Bulgaria (lev) for the period of 10 years quarterly (from 2000 to 2009).
To carry out the test analysis it is necessary to find database from EIU Country Data. Firstly the relevant countries were selected (UK and Bulgaria) and period of time (from 2000 to 2009). Then to get the exchange rates, fiscal and monetary indicators the exchange rate LCU:US (av)-XRPD BGL/USD and GBP/USD were selected in the series section. After viewing the tables with quarterly data, the figures were exported to excel. To obtain inflation rates for those two countries the same steps were followed except series section which was customer price indices (av)-LCPI.
When the data was acquired then it was possible to work out cross exchange rate BGL/GBP. Subsequently, following the formula below it was able to calculate the change in the exchange rates:
Where:
CER – Change in the Exchange Rate
ER – Exchange Rate
t – Time i.e. quarterly
The inflation rate of UK and Bulgaria was calculated by using the formula below:
Where:
Infl – Inflation Rate
CPI – Consumer Price Index
t – Time i.e. quarterly
To estimate difference of percentage change in the home country (UK) minus foreign country (Bulgaria) following formula was used:
Where:
ef – Change in the Relationship between relative Inflation Rates
Inflh – Home Country’s Inflation Rate (UK)
Inflf – Foreign Country’s Inflation Rate (Bulgaria)
≈ – symbol used for the approximate approach
Finally to indicate the positive and negative changes the following formula was created:
=IF(H13>J13, “positive”, “negative”)
After using the above methods, the following spreadsheet was created:
| BG | GB | BGL : £1 | Change In The | United Kingdom | UK inflation | Bulgaria Inflation | Bulgaria Inflation | InflUK-InfBulgaria (ef) | ef | |
| Unit | BGL/USD | GBP/USD | BGL/GBP | Exchange Rates | CPI (av) | % | CPI (av) | % | % | positive/negative |
| 2000_I | 2.0474 | 0.628062 | 3.259869249 | 92.3670 | x | 3366.767 | x | x | x | |
| 2000_II | 2.0467 | 0.660939 | 3.096654911 | -0.050067756 | 93.1330 | 0.8293 | 3342.867 | -0.7099 | 1.5392 | positive |
| 2000_III | 2.2314 | 0.67627 | 3.299569698 | 0.065527091 | 93.0670 | -0.0709 | 3463.400 | 3.6057 | -3.6765 | negative |
| 2000_IV | 2.1019 | 0.668673 | 3.143389968 | -0.047333363 | 93.6330 | 0.6082 | 3615.367 | 4.3878 | -3.7796 | negative |
(To save some space the quarter data for year 2000 is presented, to view the whole spreadsheet please see last page.)
At this point, all the necessary data was available to export to a statistics package Minitab. The entire regressions were done quarterly from 2000 to 2009.
Section 3. Test Results
In each analyse the rows with database were copied from Excel to Minitab.
3.1 Firstly, Regression Analysis: Change In The Exchange Rates versus UK Inflation was created to show the percentage change and the trend line for 10 years.
The regression equation is Y= – 0.0113 + 0.0027x. The third column “T” of the Minitab output provides test statistics. In linear regression, it tests the significance of the parameter included. In the example above, the slope parameter estimate is -0.00265 with standard deviation 0.01382. The test statistic is t = -0.00265/0.01382= -0.19175, provided in the “T” column of the Minitab output. The probability shows an extremely small value. There are only 0.19 standard errors, which mean that it is less than 95% confidence interval. Therefore, there is a chance of 84.9% that the coefficient value 0.00265 is zero, which is a very high probability. The value for “S” 0.0463833 provides the estimate for the standard deviation, and the “R-Sq” 0.1% is the square of the correlation value. This indicates the 0.0% of the variability in the ‘Change In The Exchange Rates versus UK Inflation’.
The statistical model has been used to construct straight-line predictor. Where Y= – 0.0113 + 0.0027x is the assumed regression line about which all values of x and y will fall, called the deterministic part of the model. Furthermore, ‘e’ is the error component known as the random or stochastic part of the model. This is the distance between an actual y value and the corresponding predicted value on the line, also called residual values (Crosbie, 2009). As can be noted from the chart UK inflation is stable since percentage change fluctuates from -0.5 to 2.0 and the overall trend is slightly increasing.
3.2 Secondly, consequently to the previous test the Regression Analysis: Change In The Ex versus Bulgaria Inflation was produced to show the percentage change and the trend line for 10 years.
The regression equation is Y= – 0.00853 – 0.00095x. The probability that the coefficient is -0.000949 shows an especially high value of 0.819 = 81.9%. There are only -0.23 standard errors, which mean that it is less than 95% confidence interval. The value for “S” 0.0463729 provides the estimate for the standard deviation, and the “R-Sq” 0.1% is the square of the correlation value. This indicates once more that “R-Sq (adj)” = 0.0% therefore overall regression does not fit at all in the ‘Change In The Exchange Rates versus Bulgaria Inflation’.
The actual values of the change in the exchange rate are considerably in very large distance from the assumed regression line. Therefore, the error component in average is too large. There are only few fitted values and noticeably more residual values. As can be seen from the chart Bulgaria inflation is not that stable comparing to UK since percentage change varies from -2 to 5. In opposite to UK the Bulgaria overall trend is slightly decreasing.
3.3 Thirdly, Regression Analysis: Change In The Exchange Rates versus InflUK-InfBulgar was created to show the percentage change and the trend line for 10 years.
The regression equation is Y= – 0.00897 + 0.00097x. The probability that the coefficient is 0.000974 points to an exceptionally high value of 0.796= 79.6%. There are only 0.26 standard errors, which mean that it is less than 95% confidence interval. The value for “S” 0.0463633 provides the estimate for the standard deviation, and the “R-Sq” 0.2% is the square of the correlation value. This confirms that “R-Sq (adj)” = 0.0% therefore overall regression does not fit at all in the ‘Change In The Exchange Rates versus InflUK-InfBulgar’.
The actual values of the change in the exchange rate are noticeably in very large distance from the assumed regression line. Therefore, the error component in average is excessively large. There are only few fitted values and noticeably more residual values. As can be seen from the chart Home Inflation – Foreign Inflation is not that constant since percentage change varies from -5 to 3. The overall trend is increasing to some extent.
Section 4. Reflections on results
In that research home inflation (UK) is smaller that foreign inflation (Bulgaria) Ih < If. If assumed that the exchange rate between the currencies of the two countries does not change, then the buyer’s power is greater in UK. In this case PPP does not exist.
In this project is assumed that the exchange rate will not remain constant. Therefore, accordingly to PPP theory, ef should change to maintain parity between the new index prices of the two countries. After following the ef formula, which reflects the relationship between relative inflation rates and the exchange rate, can be assumed that there are more negative rather than positive outcomes. Consequently, Bulgarian Lev depreciates more often when Bulgarian inflation exceeds UK inflation. The maximum positive result is 2.22 that occurred in 2006 and minimum negative effect is -4.68 that happened in 2007. For the reason of that foreign currency should depreciate in response to the higher inflation of Bulgaria to UK. When considering the exchange rate impact, prices of both countries will rise, which will have negative consequence on the overall rate of investment.
Inflation reflects a situation where the demand for goods and services exceeds their supply in the economy (Hall, 1982). Therefore, investors will look to invest in UK due to too high upward pressure on prices in Bulgaria. Inflation causes uncertainty about future prices, interest rates, and exchange rates, and this in turn increases the risks among potential trade partners.
Bulgarian inflation directly slow down economic development. Therefore, investors will be willing to enter into UK market where inflation is more likely to be predicted making relative prices more certain. On the other side, cannot be forgotten that the overall trend for Bulgarian inflation is decreasing. Nonetheless, investors’ decision will affect economic growth by increasing the gap between developing and developed countries. In this case inflation will inhibit investment and could result in financial recession (Hellerstein, 1997).
A particular influence on prices comes through the exchange rate. A rise in interest rates relative to those in other countries will tend to result in an increase in the amount of funds flowing into the UK, as investors are attracted to the higher sterling rates of interest. This will tend to result in an appreciation of the exchange rate against Bulgaria.
It has been shown that inflation and exchange rate affect investment in several ways, mostly restraining economic growth. The source of inflation is money and the supply of it (bu.edu, 2009).
To conclude, the project showed enough evidence to assume that there is market imperfection. Therefore, it will be necessary to reject hypothesis of absolute form and accept relative form of PPP. This version says that because of market imperfection, prices of the same basket of products in UK and Bulgaria are not necessarily equal when measured in a common currency.
Word count, excluding graphs and formulas: 1607
Sources:
Crosbie M., Statistical Methods, Part 2, Salford Business School, 2009
Dr Read J., 1998, Available at: http://www.le.ac.uk/bl/gat/virtualfc/Stats/regression/regr1.html
Fox R., Madura J., International Financial Management, Thomson Learning, London, 2007
Gerolamo D., Inflation and Its Effects on Investment, 2009, Available at: http://www.bu.edu/econ/faculty/kyn/Ec341_money/Papers/Gerolamo_paper.htm
Hall R., Inflation, Causes and Effects, Press, Chicago, 1982
Hellerstein R., The Impact of Inflation, Vol. 7, Winter, 1997
stat.yale.edu, Inference in Linear Regression, 2009, Available at: http://www.stat.yale.edu/Courses/1997-98/101/linregin.htm
| BG | GB | BGL : £1 | Change In The | United Kingdom | UK Inflation | Bulgaria Inflation | Bulgaria Inflation | InflUK-InfBulgaria (ef) | ef | |
| Unit | BGL/USD | GBP/USD | BGL/GBP | Exchange Rates | CPI (av) | % | CPI (av) | % | % | positive/negative |
| 2000_I | 2.0474 | 0.628062 | 3.259869249 | 92.3670 | x | 3366.767 | x | x | x | |
| 2000_II | 2.0467 | 0.660939 | 3.096654911 | -0.050067756 | 93.1330 | 0.8293 | 3342.867 | -0.7099 | 1.5392 | positive |
| 2000_III | 2.2314 | 0.67627 | 3.299569698 | 0.065527091 | 93.0670 | -0.0709 | 3463.400 | 3.6057 | -3.6765 | negative |
| 2000_IV | 2.1019 | 0.668673 | 3.143389968 | -0.047333363 | 93.6330 | 0.6082 | 3615.367 | 4.3878 | -3.7796 | negative |
| 2001_I | 2.2145 | 0.704722 | 3.142373872 | -0.000323248 | 93.1330 | -0.5340 | 3666.100 | 1.4033 | -1.9373 | negative |
| 2001_II | 2.3064 | 0.710379 | 3.246717597 | 0.033205382 | 94.5330 | 1.5032 | 3665.200 | -0.0245 | 1.5278 | positive |
| 2001_III | 2.142 | 0.680689 | 3.146811539 | -0.030771404 | 94.5000 | -0.0349 | 3680.100 | 0.4065 | -0.4414 | negative |
| 2001_IV | 2.2193 | 0.687616 | 3.227528155 | 0.025650286 | 94.6330 | 0.1407 | 3792.000 | 3.0407 | -2.8999 | negative |
| 2002_I | 2.2419 | 0.701754 | 3.194709257 | -0.010168431 | 94.6000 | -0.0349 | 3965.700 | 4.5807 | -4.6156 | negative |
| 2002_II | 1.9607 | 0.655953 | 2.989086108 | -0.06436365 | 95.4330 | 0.8805 | 3925.600 | -1.0112 | 1.8917 | positive |
| 2002_III | 1.9836 | 0.636943 | 3.114250412 | 0.04187377 | 95.4670 | 0.0356 | 3851.000 | -1.9003 | 1.9360 | positive |
| 2002_IV | 1.885 | 0.621311 | 3.033907335 | -0.025798528 | 96.0330 | 0.5929 | 3921.167 | 1.8220 | -1.2292 | negative |
| 2003_I | 1.7952 | 0.633312 | 2.834621798 | -0.065686099 | 96.0000 | -0.0344 | 3989.700 | 1.7478 | -1.7821 | negative |
| 2003_II | 1.71159 | 0.604997 | 2.829088409 | -0.001952073 | 96.6330 | 0.6594 | 3967.800 | -0.5489 | 1.2083 | positive |
| 2003_III | 1.6785 | 0.601685 | 2.789665689 | -0.013934778 | 96.8000 | 0.1728 | 3968.700 | 0.0227 | 0.1501 | positive |
| 2003_IV | 1.5486 | 0.560475 | 2.763013515 | -0.009553895 | 97.3000 | 0.5165 | 4105.133 | 3.4377 | -2.9212 | negative |
| 2004_I | 1.6 | 0.543478 | 2.944001413 | 0.065503805 | 97.2000 | -0.1028 | 4244.700 | 3.3998 | -3.5026 | negative |
| 2004_II | 1.6091 | 0.551694 | 2.916653072 | -0.009289514 | 98.0000 | 0.8230 | 4235.300 | -0.2215 | 1.0445 | positive |
| 2004_III | 1.5761 | 0.552792 | 2.851162824 | -0.022453904 | 98.0330 | 0.0337 | 4236.967 | 0.0394 | -0.0057 | negative |
| 2004_IV | 1.4359 | 0.521921 | 2.75118265 | -0.035066455 | 98.7000 | 0.6804 | 4299.867 | 1.4846 | -0.8042 | negative |
| 2005_I | 1.5087 | 0.529437 | 2.849630834 | 0.035783951 | 98.9000 | 0.2026 | 4407.067 | 2.4931 | -2.2905 | negative |
| 2005_II | 1.6175 | 0.557724 | 2.900180017 | 0.017738853 | 99.9000 | 1.0111 | 4443.233 | 0.8206 | 0.1905 | positive |
| 2005_III | 1.6242 | 0.565099 | 2.874186647 | -0.008962675 | 100.3670 | 0.4675 | 4439.267 | -0.0893 | 0.5567 | positive |
| 2005_IV | 1.6579 | 0.581801 | 2.849599777 | -0.008554375 | 100.8000 | 0.4314 | 4584.767 | 3.2776 | -2.8462 | negative |
| 2006_I | 1.6159 | 0.574944 | 2.810534591 | -0.013709008 | 100.8330 | 0.0327 | 4760.433 | 3.8315 | -3.7988 | negative |
| 2006_II | 1.5385 | 0.540804 | 2.844838426 | 0.012205448 | 102.1330 | 1.2893 | 4811.100 | 1.0643 | 0.2249 | positive |
| 2006_III | 1.5449 | 0.534302 | 2.891435929 | 0.016379666 | 102.8000 | 0.6531 | 4735.633 | -1.5686 | 2.2217 | positive |
| 2006_IV | 1.4851 | 0.510569 | 2.90871557 | 0.005976145 | 103.5330 | 0.7130 | 4865.100 | 2.7339 | -2.0209 | negative |
| 2007_I | 1.4686 | 0.508001 | 2.890939191 | -0.006111419 | 103.7000 | 0.1613 | 5009.500 | 2.9681 | -2.8068 | negative |
| 2007_II | 1.4482 | 0.49843 | 2.905523343 | 0.00504478 | 104.7670 | 1.0289 | 5036.300 | 0.5350 | 0.4939 | positive |
| 2007_III | 1.3794 | 0.490461 | 2.812456036 | -0.032031168 | 104.6330 | -0.1279 | 5265.400 | 4.5490 | -4.6769 | negative |
| 2007_IV | 1.3312 | 0.503956 | 2.641500448 | -0.060785159 | 105.7000 | 1.0198 | 5472.033 | 3.9244 | -2.9046 | negative |
| 2008_I | 1.2369 | 0.503651 | 2.455867257 | -0.070275661 | 106.1670 | 0.4418 | 5674.867 | 3.7067 | -3.2649 | negative |
| 2008_II | 1.2407 | 0.502361 | 2.469737898 | 0.00564796 | 108.3000 | 2.0091 | 5790.100 | 2.0306 | -0.0215 | negative |
| 2008_III | 1.3674 | 0.561672 | 2.434516942 | -0.014261009 | 109.6670 | 1.2622 | 5906.233 | 2.0057 | -0.7435 | negative |
| 2008_IV | 1.3873 | 0.684041 | 2.028094807 | -0.166941592 | 109.8000 | 0.1213 | 5978.467 | 1.2230 | -1.1017 | negative |
| 2009_I | 1.4697 | 0.699301 | 2.101670096 | 0.036278032 | 109.3670 | -0.3944 | 6014.600 | 0.6044 | -0.9987 | negative |
| 2009_II | 1.3838 | 0.607829 | 2.276627143 | 0.083246675 | 110.6000 | 1.1274 | 6029.567 | 0.2488 | 0.8786 | positive |
| 2009_III | 1.3357 | 0.624844 | 2.137653558 | -0.06104363 | 111.2670 | 0.6031 | 5965.867 | -1.0565 | 1.6595 | positive |
| 2009_IV | n.a. | n.a. | n.a. | n.a. | n.a. | n.a. | n.a. | n.a. | n.a. | n.a. |
