Question

the relationship between nominal exchange rate and relative prices .from the annual observations from 2000 to 2014, the following regression result were obtained , where Y =exchange rate of the Nigeria naira to the America dollar (#/$) and X=ratio of the US consumer price index to the Nigerian consumer price index ; that is X represent the relative prices in the two countries Y estimate =6.682- 4.318X. r=0.528, SE =(1.22) (1.333). interprete this regression. How would you interpret r^2. does the negative value of X make economic sense. what is underlying economic theory.

Answer 1

Regression Interpretation

If the relative price index between the US and the Nigeria rise by 1 unit, then then this leads to a decline in the dollar value of Nigerian currency by 4.318 units or in words ff the relative price index between the US and the Nigeria rise by 1 unit, then number of units of Nigerian currency required to purchase 1 dollar falls by 4.318 Nigerian currency units.  

R² Interpretation

Since R²=0.528, the this means that approximately 53% of the variation in the Nigerian and Dollar exchange rate is explained by the variation in the relative prices between the 2 countries.

Negative coefficient of X makes sense as if the inflation rate in the US is higher than the inflation rate in Nigeria (so the index of relative price rises), then this leads to a depreciation in US dollar vis-a-vis the Nigerian currency (or appreciation in the Nigerian currency the vis-a-vis US dollar)  

The underlying economic theory that explains this is the Relative form of Purchasing Power Parity (PPP) theory