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Mathematically, the exchange rate determination under the PPP model is expressed as:
lnet = lnpt – lnpt*
where et is the nominal exchange rate, pt and pt* are domestic and foreign prices respectively.
The PPP model which is specified as a restrictive error-correction form, following that used in Cheung et al. (2004) is written as:
lnet+h – lnet = ?o + ?1 (lnet - ?o – ?1lnp~t) + ?t
where p~t is the domestic price level relative to the foreign price level, ?t is a zero mean error term, and h is the forecast horizon. The restrictive setup explicitly allows the variation of the exchange rate as a correction of its last-period deviation from a long-run equilibrium
b...
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