THE EFFECT OF MACROECONOMIC VARIABLE TOWARDS PURCHASING POWER PARITY

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1 THE EFFECT OF MACROECONOMIC VARIABLE TOWARDS PURCHASING POWER PARITY Izzaamirah Ishak 1 Muhammad Hazim Ariff Mohd Hellmy 2 Abstract Purchasing Power Parity involves a relationship between a country s foreign exchange rate and the level or movement of its national price level relative to that of a foreign country. The purpose of this study is to examine impact of macroeconomic variable such as Exchange Rate, Gross Domestic Product (GDP) and Consumer Price Index (CPI) towards Purchasing Power Parity (PPP). The method that been used is regression to ascertain the causal effect of one variable upon another. The study period uses is fifteen years from The data were collected from Bank Negara Malaysia (BNM), Bursa Malaysia, World Bank, and Department of Statistic. The research shows that all macroeconomics variables are associated with Purchasing Power Parity Keywords: Gross Domestic Product, Consumer Price Index, Purchasing Power Parity 2017 JHLCB Introduction Purchasing Power Parity is an economic theory that estimates the amount of adjustment needed on the exchange rate between countries in order for the exchange to be equivalent to each currency purchasing power. According to Thomas E. Copeland, J. F. (2005) Purchasing Power Parity involves a relationship between a country s foreign exchange rate and the level of movement of its national price level relative to that particular foreign country. As in Jerry Coakley (2004), Purchasing Power Parity theory hold the nominal exchange rate between two countries and it should equal to the ratio and aggregate price between two countries. Specifically, Purchasing Power Parity implies that one basket of goods should be equal or should cost the same in different country which are the goods have been purchased after adjustment has been made for the exchange rate between particular countries. Purchasing Power Parity doctrine is an expression of the law of one price. In competitive market, the exchange-adjusted prices of identical tradable goods and financial assets must be equal 1 College of Business Management and Accounting, Universiti Tenaga Nasional, Pahang Tel: Izza@uniten.edu.my 2 College of Business Management and Accounting, Universiti Tenaga Nasional, Pahang Tel: hazimariff@yahoo.com 135

2 worldwide. The main proxy of Purchasing Power Parity is exchange rate, (Copeland L., 2007). For the macroeconomic variable, such as exchange rate, the other name of exchange rate are known as nominal exchange rate. But overall, exchange rate are the most used indicator in macroeconomic variable. If people are asking about exchange rate without specifying it, it would know as exchange rate. Purchasing Power Parity also can give a simple example for those who want to understand it further more. For example, we assume that each country produces a single good (which is different from other country producing good) simplifies the theory of Purchasing Power Parity. Meanwhile, the Gross Domestic Product (GDP) growth drops drastically after the Malaysia Financial Crisis in year 1997 and Global Financial Crisis in the year of The fact is presented in Figure 1 below, sources from World Bank. In the year of 1997, the GDP growth rate is +7.3% and it had been decrease to -7.4% in the year of While in 2008, the GDP rate is +4.8 and it starts to show decreasing number at the third and fourth quarter on that year. In year of 2009, the GDP rate is decreasing until it reach to -1.5% (International Monetary Fund, 2005). Figure 1: Malaysian GDP Per Capita from 1990 until 2015 Most researchers who have done their research on the Purchasing Power Parity are mainly focus on the developed country rather than the developing country (Al-Zyoud, 2015; Jerry Coakley, 2004). The developed country such as United States, Canada, and United Kingdom. Researcher also have done their research on a less developed country such as of Philippines, Thailand and Indonesia (Asian country). Thus, whether the research finding is applicable in emerging market (particularly in Malaysia) or not. It is also to re-examine the Purchasing Power Parity in Malaysia as in our ringgit Malaysia has fallen recently. When ringgit Malaysia has fallen, the exchange rate decrease. When the exchange rate decrease, it will affect the Purchasing Power Parity, and it will decrease the Purchasing Power Parity in Malaysia. Therefore, this paper will answer is the macroeconomics variables effects purchasing power parity? Essentially, the data were collected annually for 15 years from year 2001 until 2015 with 60 sample size. The data consist of Exchange Rate, Consumer Price Index and Gross Domestic Product. 136

3 According to Coakley, J. et al, (2005) they tests general relative Purchasing Power Parity (PPP), defined as a long-run unit elasticity of the nominal exchange rate with respect to relative national prices. And the results shows, as a long run relation, Purchasing Power Parity perform well in the generalized model. This result is consistent with Christev, A., & Noorbakhsh, A. (2000), where they observed in six Central and East European countries using co-integration analysis. Besides that, Kargbo J.M. (2006) also using Johansen s cointegration method to annual data on official and black market exchange rates, and the GDP deflators of 40 countries covering the period. The purpose of the study is to determine whether there is empirical support for long-run Purchasing Power Parity in African countries and the result shows that Purchasing Power Parity supported thus it can be guide for exchange rate determination. For movement between Canadian dollar and US dollar exchange rates, Al-Zyoud H., (2015) used Engle-Granger cointegration test with monthly data for the period 1995:01 to 2008:08. The study concluded that there is a significant movement in explaining the actual exchange rate between US and Canada. The Consumer Price Index also has been tested towards Purchasing Power Parity in previous literature by Xhu, Z. (2002). The author addresses the issue of using aggregate price indices for Purchasing Power Parity (PPP) tests and fitness of Purchasing Power Parity as model for exchange rate forecasting & used Consumer Price Index (CPI), Wholesale Price Index (WPI), and price index of traded goods (TPI). The result shows that the two price indices, CPI and WPI, are not suitable for PPP tests and for exchange rate forecasting. Based on Apte, P. et al. (2004), analyses the exchange rate in a no-arbitrage or real business cycle equilibrium model and provides empirical evidence for this model vis-a-vis Purchasing Power Parity. Their contribution is to show, based on a generalization of the equilibrium model of exchange rates, that (i) the test equation linking the exchange rate to fundamentals should allow for international heterogeneity in time preferences and risk attitudes, as well as noise that is, the model should not be tested as an exact relation; (ii) empirical work should use levels of variables rather than first differences; and (iii) tests on the existence of long-run relations should be complemented by test on the signs of the coefficients. The result shows that, as a long run relation, Purchasing Power Parity perform well on a long run. Besides that, a set of newly developed unit root tests, which account for both nonlinearity and multiple smooth temporary breaks in series, to the real effective exchange rates (REERs) of 23 developed countries being tested by Kutan, A. M., and Zhou, S. (2015). The result shows that PPP generally holds for various currency-based real rates. There is evidence in favour of linear stationarity in REERs for highly integrated economies. For short run and long run relationships, Fadli Fizari Abu Hassan Asari et. al (2011) determine whether or not short run and long run relationships exist between the Purchasing Power Parity and other macroeconomic variables such as Exchange rate, Gross Domestic Product, Money Supply and Interest rate. As a result, all macroeconomic variable were found significantly influence the Purchasing Power Parity. From above information gathered, the macroeconomics variables such as Exchange rate, CPI and GDP should be combine to assess whether they would significantly affect the company performance by using regression analysis. 137

4 Therefore, financial ratio and macroeconomic variable such as GDP should be combined to assess whether they would significantly affect the Purchasing Power Parity. However, this study would use regression analysis to regress the model. Methodology Pearson correlation analysis and regression analysis were used. All macroeconomic variables which is Exchange Rate, GDP and Consumer Price Index represent independent variables meanwhile Purchasing Power Parity represent dependent variable in this study. The Figure 2 below, shows the theoretical framework has been conducted throughout the research. Figure 2 Theoretical framework Prior to the analysis above, the correlation and regression results are generated by IBM SPSS. Thus, the multiple regression models are presented below: (1) where βi, i=1,2,3,4 is the coefficient of the independent variables, β0 is y-intercept and ε is error terms occur in the model. The hypotheses that being conducted in this research are: H1a: There is a relationship between each macroeconomics variables and Purchasing Power Parity. H2a: There is an impact of macroeconomics variables (ER, GDP, and CPI) towards Purchasing Power Parity. 138

5 Result and Discussion Table 1 Pearson correlation coefficient analysis Variables Pearson Correlation Coefficient The p-value Exchange rate GDP CPI From Table 2, it shows a positive moderate relationship between exchange rate and purchasing power parity at 53.4%. Meanwhile there is a strong positive relationship between Gross Domestic Product (GDP) and Purchasing Power Parity by and lastly, a strong positive relationship between Consumer Price Index (CPI) and purchasing power parity by The p-values indicates all the variables are significant at 5% significant level. A part of that, result for regression analysis is shown as follows: Table 2 Statistics value Measurement Value R F-statistics p-value From Table 3, it shows 98.5% variance in Purchasing Power Parity (PPP) explained by Exchange rate, Gross Domestic Product, and Consumer Price Index. Meanwhile F- statistics indicates how fit the variables with model. In this study, F-statistics is , thus all independent variable give impact to the Purchasing Power Parity with 5% significant level. Furthermore, the model is also fit enough and affecting the Purchasing Power Parity. Table 3 Coefficient analysis table Variables B Std. Error t-statistics p-value Constant Exchange rate GDP CPI Table 4 below shows the regression result that indicates which one among the four variables influence the most on purchasing power parity. All the variables are significant at 5% level of significance except for Exchange Rate. However, there is an insignificant negative relationship between Exchange Rate and Purchasing power parity. Whereas there is a positive relationship between GDP and Purchasing Power Parity. For every one unit increase in GDP, Purchasing Power Parity will increase by unit while the other variable are remain fix. Lastly, there is a positive relationship between Consumer Price Index and Purchasing Power Parity. For every one unit increase in CPI, Purchasing Power Parity will 139

6 increase by unit while the other variable are remain fix. Thus, the multiple regression would be: In line with the hypotheses before, the summary of the discussion above shows in the Table 4 below: Table 4 Summary Hypothesis Acceptance There is a relationship between Exchange Accept with positive relationship Rate and Purchasing Power Parity There is a relationship between GDP and Accept with positive relationship Purchasing Power Parity There is a relationship between Consumer Accept with positive relationship Price Index and Purchasing Power Parity There is an impact of macroeconomics Accept with significant regression model variables towards Purchasing Power Parity (2) Conclusion In conclusion, this study found that all variables tested are positive correlated to Purchasing Power Parity. Whenever Exchange Rate decrease, the Purchasing Power Parity would decrease too. The more GDP the more Purchasing Power Parity to the consumer. Whereas, the higher Consumer Price Index, the higher Purchasing Power Parity and vice versa. As overall, there is an impact of macroeconomic variable towards Purchasing Power Parity but exchange rate give less affect to the purchasing power parity at 5% significant level. However, this study should be improved by adding more variable such as unemployment rate to get a better results and understanding about economics in Malaysia. Besides, using the data of more than 10 years. For example, 20 years and the result will more accurate. As others know, in economy industry, especially in Malaysian economy, every 10 or 15 years Malaysian economy will having an economy recession. So by doing more than 10 years, researcher could see the trend of data that they use especially on macroeconomic data. References Al-Zyoud, H. (2015). An Empirical Test of Purchasing Power Parity Theory for Canadian Dollar-US Dollar Exchange Rates. International Journal of Economics and Finance, 7(3), 233. Apte, P., Sercu, P., & Uppal, R. (2004). The exchange rate and purchasing power parity: extending the theory and tests. Journal of International Money and Finance, 23(4),

7 Christev, A., & Noorbakhsh, A. (2000). Long-Run Purchasing Power Parity, Prices and Exchange Rates in Transition: The Case of Six-This paper presents empirical results on the hypothesis of long-run purchasing power parity (PPP) with. Global Finance Journal, 11(1-2), Coakley, J., Flood, R. P., Fuertes, A. M., & Taylor, M. P. (2005). Purchasing power parity and the theory of general relativity: the first tests. Journal of International Money and Finance, 24(2), Copeland, L. (2007). Arbitrage Bounds and the Time Series Properties of the Discount on UK Closed End Mutual Funds. Journal of Business Finance & Accounting, 34(1 2), Fadli Fizari Abu Hassan Asari, M. R. (2011). A Study In Short and Long Run Determinants of Purchasing Power Parity. World Applied Sciences Journal, Jerry Coakley, R. P. (2004). Purchasing Power Parity and the Theory of General Relativity: The First Tests. Journal of International Money and Finance, Kargbo, J. M. (2006). Purchasing power parity and real exchange rate behaviour in Africa. Applied Financial Economics, 16(1-2), Kutan, A. M., & Zhou, S. (2015). PPP may hold better than you think: Smooth breaks and non-linear mean reversion in real effective exchange rates. Economic Systems, 39(2), Thomas E. Copeland, J. F. (2005). Financial Theory and Corporate Policy. Pearson, Addison Wesley. Xhu, Z. (2002). Purchasing Power Parity, Price Indices, and Exchange Rate Forecasts. Journal of International Money and Finance,