Question

19. The following regression model was estimated to forecast the value of the Indian rupee (INR):

    INRt =a0 +a1INTt +a2INFt−1 +t,

    where INR is the quarterly change in the rupee, INT is the real interest rate differential in period t between the U.S. and India, and INF is the inflation rate differential between the U.S. and India in the previous period. Regression results indicate coefficients of a0 = .003; a1 = −.5; and a2 = .8. Assume that INFt − 1 = 2%. However, the interest rate differential is not known at the beginning of period t and must be estimated. You have developed the following probability distribution:

Probability Possible Outcome

30% -2%

40% -3%

30% -4%

Find the expected change in the Indian rupee in period t

Answer 1

INR; = do +aINT+ a2INF:-1+"

E[INT] = (-.02)(-3) + (-03)(:4) + (-04)(.3) = -3.00% INR, = .003 +(-.5)(-03) + (.8)(.02) = 3.40%

Hence, the expected change in the Indian rupee in period t = 3.40%