Final answer:
The question involves the relative Purchasing Power Parity (PPP) theory and its testing through a regression model in a business or economics context at the college level. A t-test is performed to test for a linear relationship, using statistical tools to evaluate whether the hypothesis that there is no effect (α=0) or a proportional effect (β=1) can be rejected.
Step-by-step explanation:
The student's question pertains to testing the theory of relative Purchasing Power Parity (PPP) using a regression model. Specifically, the equation Ef,t = α + β (Idc,t - Ifc,t) + εt is used to assess whether changes in inflation differentials (Idc,t - Ifc,t) can predict future exchange rates (Ef,t). To test the hypothesis that there is a linear relationship between these variables, the hypotheses to be tested are H0: α=0 and β=1 under relative PPP.
In order to test this hypothesis, one can use a linear regression t-test to determine if the sample data provides enough evidence to reject the null hypothesis. The focus will be on the population correlation coefficient ρ, and whether it is significantly different from zero. The use of statistical tools like the TI-83, 83+, 84, 84+ calculator with the LinRegTTest function can facilitate this.
Understanding PPP is essential for predicting how exchange rates will fluctuate over time, as they often move towards the PPP exchange rate after adjusting for relative inflation rates, rates of return, and shifts in interest rates and inflation expectations. Therefore, knowledge of PPP is crucial for tracking and anticipating exchange rate movements because it explains how exchange rates adjust in the short and medium run.