Assume a forecasting model uses inflation differentials and interest rate differentials to forecast the exchange rate. Assume the regression coefficient of the interest rate differential variable is -.5, and the coefficient of the inflation differential variable is .4. Which of the following is true?
A) The interest rate variable is inversely related to the exchange rate, and the inflation variable is directly (positively) related to the interest rate variable.
B) The interest rate variable is inversely related to the exchange rate, and the inflation variable is directly related to the exchange rate.
C) The interest rate variable is directly related to the exchange rate, and the inflation variable is directly related to the exchange rate.
D) The interest rate variable is directly related to the exchange rate, and the inflation variable is directly related to the interest rate variable.

Question

Quizplus · Accepted Answer

According to the given information, the regression coefficient of the interest rate differential variable is -.5, meaning that an increase in the interest rate differential is associated with a decrease in the exchange rate. Similarly, the coefficient of the inflation differential variable is .4, indicating that an increase in the inflation differential is associated with an increase in the exchange rate. Therefore, the interest rate variable is inversely related to the exchange rate, and the inflation variable is directly related to the exchange rate. Option B correctly reflects this relationship.

Assume a Forecasting Model Uses Inflation Differentials and Interest Rate