HO CHI MINH CITY OPEN UNIVERSITY ADVANCED EDUCATION DEPARTMENT SUBJECT: INTERNATIONAL FINANCIAL MANAGEMENT: Do inflation differentials explain exchange rate? HO CHI MINH CITY - 2018 TABLE OF CONTENTS PART 1: INTRODUCTION PART 2: DATA PART 3: ANALYSIS PART 4: CONCLUSION PART 5: REFERENCES PART 1: INTRODUCTION The influence of inflation differentials on exchange rate has been an interesting subject that economists want to research for so long In this paper, we will answer the question whether inflation differentials explain exchange rate between two countries This research paper is significant due to it help us find out the true correlation between these two variables, and understand more about it To answer the question above, the analysis is based on the PPP theory, we also use regression method For more specific, we focus on two country that we assume they are representative: United Kingdom – home country and Switzerland – foreign country PART 2: DATA Our dataset consist of two variables: inflation differentials and exchange rate Variable Inflation differentials Exchange rate Variable characteristic The difference in inflation between two countries (independent variable) The exchange rate CHF/GBP (dependent variable) Moreover, we also need some more data to calculate the main variable We looked up on http://www.worldbank.org/ and had specific information about each country’s inflation and its exchange rate quoted in American terms from 2007 to 2016 But we want to see more how it was in a long-run so the data we have is from 2000 to 2016 year 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 United Kingdom Switzerland Exchange rate Exchange rate Inflation inflation (USD/GBP) (USD/CHF) 0.660930833 0.785269 1.6888425 1.543392 0.694655 1.235895 1.687615 0.98902 0.667223333 1.256192 1.5586075 0.642699 0.6124725 1.362922 1.346650833 0.638349 0.54618 1.344596 1.243495833 0.802903 0.549998333 2.049668 1.245176667 1.171972 0.543486667 2.333528 1.253843333 1.058778 0.499771667 2.321036 1.200365833 0.732636 0.54396625 3.613499 1.08309 2.426637 0.641919263 2.166231 1.088141696 -0.48058 0.647179346 3.285714 1.042905646 0.69851 0.624140836 4.48424 0.888042028 0.231346 0.633046989 2.82171 0.937684481 -0.69254 0.639660578 2.554547 0.926903548 -0.21732 0.607729627 1.460192 0.916151047 -0.01319 0.654545479 0.050021 0.962381328 -1.14392 0.740634464 0.641613 0.985394394 -0.43463 Source: World Bank By using cross rate calculation and calculating the inflation differentials, we have: year 2000 2001 2002 2003 Inflation Differentials -0.758123 0.246875 0.613493 0.724573 Exchange rate (CHF/GBP) 0.391351374 0.411619356 0.42808939 0.454811659 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 0.541693 0.877696 1.27475 1.5884 1.186862 2.646811 2.587204 4.252894 3.51425 2.771867 1.473382 1.193941 1.076243 0.439229457 0.441703052 0.433456599 0.41634946 0.502235502 0.589922494 0.620554072 0.702828037 0.675117272 0.690104789 0.663350906 0.680131108 0.751612215 The exchange rate continue to show an upward tendency Exchage rate CHF/GBP 0.8 0.7 0.6 0.5 0.4 0.3 0.2 0.1 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 More information about Inflation Differentials: - - < inflation differentials < 1: the Switzerland’s economy somehow grows stronger than UK’s economy At the same time, if Switzerland attempt to raise the exchange rate, there will have the opportunity for Switzerland’s export to UK, and vice versa Inflation differentials = 1: two countries’ economies are the same Inflation differentials > 1: the UK’s economy somehow grows stronger than Switzerland At the same time, if UK attempt to raise the exchange rate, there will have the opportunity for UK’s export to Switzerland, and vice versa Inflation Differentials 2016 2014 2012 2010 2008 2006 2004 2002 2000 -2 -1 PART 3: ANALYSIS Before figure out the main answer, we consider to take a look in a single country As we learnt, inflation is one of the factors that affect the exchange rate indirectly through the interest But in this part, we just focus on how the inflation influent on the exchange rate We want to make sure that in each country there is the correlation between inflation and exchange rate So that we can have a basis to answer the main question By using regression we have the following results of Switzerland and United Kingdom (2007-2016): Switzerland Number of obs = 57 F( 1, 55) = 24.65 Prob > F = 0.0000 R-squared = 0.2343 Root MSE = 1.1069 | Robust ex234 | Coef Std Err t P>|t| [95% Conf Interval] -+ inf234 | 2524599 050854 4.96 0.000 1505462 3543736 _cons | 1.56885 1530782 10.25 0.000 1.262075 1.875626 According to the result table of Switzerland, the coefficient of inflation rate is positive (0.2524599) which means changing the inflation rate lead to the change in exchange rate United Kingdom Number of obs = 28 F( 1, 26) = 11.74 Prob > F = 0.0020 R-squared = 0.1665 Root MSE = 0494 -| Robust ex251 | Coef Std Err t P>|t| [95% Conf Interval] -+ inf251 | -.0122601 0035777 -3.43 0.002 -.0196141 -.004906 _cons | 647504 0160487 40.35 0.000 6145154 6804926 -5 Alike Switzerland’s result table, United Kingdom also has the correlation between inflation and ex, but in negative way (the coefficient of inflation rate is -0.0122601) Normally, it is positive (like Switzerland), but the UK government intervened in the exchange rate to prevent it from changing too much, which help UK’s economy more stable Analyzing whether inflation differentials explain exchange rate: As we just show that there is the correlation between inflation and exchange rate in a single country, now we will analyze how the exchange rate be effected when two countries’ inflation change Here are the result table after we use regression to find out whether there correlation existed (2000-2016): SUMMARY OUTPUT Regression Statistics Multiple R R Square Adjusted R Square Standard Error Observations ANOVA Intercept inflation differentials 0.682214749 0.465416964 0.429778095 0.096521887 17 Coefficients 0.4418 Standard Error 0.0373 t Stat 11.8540 P-value 0.0000 0.0690 0.0191 3.6138 0.0026 As you can see the R-Square statistic suggests that about 47% of the variation in exchange rate is explained by inflation differentials between two countries So at first the correlation is confirmed although the influence is not really strong but enough To know better about this connection the coefficient of differential inflation – the estimate of the so-called slope – is about 0.07, which suggest that if the differential inflation change unit, the exchange rate (CHF/GBP) change 0.07 unit This is not a great change, because these years not only UK but Switzerland also try to remain low inflation to heighten the currencies’ values Therefore, there still has the bond between these two variable no matter how Moreover, if the inflation differentials is still increasing, it will be more advantage for UK to develop (in the context we are researching) This was proved in several recent years (2010-2017) when UK’s export to Switzerland increased Export - Import between UK and Switzerland 1E+11 8E+10 6E+10 4E+10 2E+10 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 euk-sw iuk-sw UN Comtrade Besides, let’s consider another case – the main case we planned to consider In this case, we also analyze these two country but only from 2007 to 2016 So we have this result table: SUMMARY OUTPUT Regression Statistics Multiple R R Square Adjusted R Square Standard Error Observations ANOVA Intercept inflation differentials 0.269822794 0.07280434 -0.043095117 0.103835175 10 Coefficients 0.5734 0.0250 Standard Error 0.0777 0.0316 t Stat 7.3827 0.7926 P-value 0.000 0.451 According to the P-value > 5% which shows that there is no statistical significance correlation in this case PART 4: CONCLUSION Following the analysis above, we lead to the conclusion that is in a specific case we consider (2007-2016), there is not a connection between two variables However, that is just in a short-run We also consider in longrun (2000-2016) and find out the correlation exists This paper research just uses two variables, in fact, there are many components that effect the exchange rate like interest rates, income levels, government controls and expectations of future rate or the lack of substitutes for some traded goods (reasons why PPP does not occur consistently) Therefore, our final conclusion is that the inflation differentials can somehow explain the exchange rate between two countries PART 5: REFERENCES https://vn.answers.yahoo.com/question/index?qid=20110526175240AAI9z6H&guccounter=1 https://people.duke.edu/~rnau/rsquared.htm http://www.academia.edu/9551194/%E1%BB%A8NG_D%E1%BB%A4NG_EXCEL_TRONG_H%E1%B B%92I_QUY_T%C6%AF%C6%A0NG_QUAN_V%C3%80_D%E1%BB%B0_B%C3%81O_KINH_T%E 1%BA%BE https://xe.com/currencycharts/ http://dergipark.gov.tr/download/article-file/366198 http://econ.sciences-po.fr/sites/default/files/file/ncoeurdacier/cours5CoeurdacierPEI_web.pdf http://icfb.rs.opf.slu.cz/sites/icfb.rs.opf.slu.cz/files/urbanovsky.pdf ... United Kingdom – home country and Switzerland – foreign country PART 2: DATA Our dataset consist of two variables: inflation differentials and exchange rate Variable Inflation differentials Exchange. .. influence of inflation differentials on exchange rate has been an interesting subject that economists want to research for so long In this paper, we will answer the question whether inflation differentials. .. 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 United Kingdom Switzerland Exchange rate Exchange rate Inflation inflation (USD/GBP) (USD/CHF) 0.660930833 0.785269 1.6888425 1.543392