Analysis

The inflation rate for both the countries was calculated on a monthly basis using the data of the
Consumer Price Index.
Purchasing power of 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's purchasing power. The following Null Hypothesis can be formed, if the PPP holds
true:
H0: The difference in inflation rates and difference in exchange rates are related and belong to
similar population set (1= 2)
We ran the t-test on the difference between inflation rates in US and japan and difference
between exchange rates for the period between Jan 2010-Dec 2014. This resulted in the
following:

Table 1: t-test Table

As can be seen from the above table, value of t-stat lies between the t-critical value range, which
means both sets of data are similar and come from similar population set. Therefore, we can
assume that the difference in exchange rates are somehow related to the difference in inflation
rates. We thus conclude, that PPP holds between Japan and USA.

Next, we took the lag values for three periods. A multiple regression was run by taking the
current as well as lagged values of difference in inflation rate as independent variable and
difference in exchange rates as dependent variables.

Table 2: Multiple Regression Result Table

We can see that the p-value is greater than 0.05 in all the variables. This tells us that Impact of
change in inflation rate between the two countries are impacting the change in exchange rates.
The impact is not felt immediately, instead it is also felt over the next 2-3 periods to come.
During 2012, Japan was in a continuous state of deflation sine the past 15 years, due to which
people started holding money and stopped them from any major investments thus reducing the
flow of money in the market. Also, during the same period, the prices of other Asian countries
such as China started rising which created a gap between them and Japan. During April 2014,
there was a rise in sales tax due to which people had lesser money to spend resulting in effect on
prices of the commodities. Then during November in the same year, the oil prices started sliding
which resulted in the decrease in the inflation rate. Also due to the depreciation in currency, the
imports are getting costlier which ultimately leads to an increase in inflation rate. While in the
US, the fall in oil prices in 2014 have resulted in