The relationship between nominal exchange rate and relative prices. From annual observations from 1985 to 2005, the following regression results were obtained, whereY=exchange rate of the Canadian dollar to the U.S. dollar (CD$) andX= ratio of the U.S. consumer price index to the Canadian consumer price index; that is, Xrepresents the relative prices in the two countries: Yˆt= -0.912+2.250Xtr2=0.440 se=0.096
a. Interpret this regression. How would you interpretr2?
b. Does the positive value ofXtmake economic sense? What is the underlying economic theory?
c. Suppose we were to redefineXas the ratio of the Canadian CPI to the U.S. CPI. Would that change the sign ofX? Why?