The following regression was conducted for the exchange rate of the British pound (BP): Regression results indicate that a₀ = 0 and a₁ = 2. Therefore:

Question

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The regression results indicate that the coefficient for the lag of the exchange rate (a₀) is not significant (0), but the coefficient for the lag of the inflation differential (a₁) is significant (2). This suggests that the exchange rate change was primarily driven by the inflation differential between the UK and another country. As a result, purchasing power parity (PPP) is likely to have underestimated the exchange rate change during the period under examination. Therefore, the correct answer is C. It is not possible to determine whether PPP will overestimate or underestimate the exchange rate change in the future based on this regression.

The Following Regression Was Conducted for the Exchange Rate of the British