Deck 16: Price Levels and the Exchange Rate in the Long Run

Question 1

The monetary approach makes the general prediction that

A) the exchange rate, which is the relative price of American and European money, is fully determined in the long run by the relative supplies of those monies.
B) the exchange rate, which is the relative price of American and European money, is fully determined in the short run by the relative supplies of those monies and the relative demands for them.
C) the exchange rate, which is the relative price of American and European money, is fully determined in the short run and long run by the relative supplies of those monies and the relative demands for them.
D) the exchange rate, which is the relative price of American and European money, is fully determined in the long run by the relative supplies of those monies and the relative demands for them.
E) the money supply in the U.S. will adjust to European monetary equilibrium.

Answer 1

D

Question 2

Explain the Law of One Price. Give an example.

Answer 2

The law of one price states that in competitive markets free of transportation costs and trade barriers, identical goods sold in different countries must sell for the same price when expressed in terms of the same currency.
If, for example, the price of the same sweater was cheaper in London than in New York, U.S. importers and British exporters would have an incentive to buy sweaters in London and ship them to New York, pushing the London price up and the New York price down, until both were equal.

Question 3

Which of the following statements is the most accurate?

A) The law of one price applies only to the general price level.
B) The law of one price applies to the general price level while PPP applies to individual commodities.
C) The law of one price applies to individual commodities while PPP applies to both the general price level and to individual commodities.
D) PPP applies only to individual commodities.
E) The law of one price applies to individual commodities while PPP applies to the general price level.

Answer 3

E

Question 4

Under the monetary approach to the exchange rate theory, money supply growth at a constant rate

A) eventually results in ongoing price level deflation at the same rate, but changes in this long-run deflation rate do not affect the full-employment output level or the long-run relative prices of goods and services.
B) eventually results in ongoing price level inflation at the same rate, but changes in this long-run inflation rate do affect the full-employment output level and the long-run relative prices of goods and services.
C) eventually results in ongoing price level inflation at the same rate, but changes in this long-run inflation rate do not affect the full-employment output level or the long-run relative prices of goods and services.
D) eventually results in ongoing price level inflation at the same rate, but changes in this long-run inflation rate do not affect the full-employment output level, only the long-run relative prices of goods and services.
E) eventually results in ongoing price level deflation at the same rate, but changes in this long-run deflation rate do not affect the full-employment output level, only the long-run relative prices of goods and services.

Question 5

Which of the following statements is the most accurate? The law of one price states:

A) in competitive markets free of transportation costs and official barrier to trade, identical goods sold in different countries must sell for the same price when their prices are expressed in terms of the same currency.
B) in competitive markets free of transportation costs and official barrier to trade, identical goods sold in the same country must sell for the same price when their prices are expressed in terms of the same currency.
C) in competitive markets free of transportation costs and official barrier to trade, identical goods sold in different countries must sell for the same price.
D) identical goods sold in different countries must sell for the same price when their prices are expressed in terms of the same currency.
E) in competitive markets free of official barrier to trade, identical goods are sold at the same price regardless of transportation costs.

Question 6

Discuss the differences between Absolute PPP and Relative PPP.

Question 7

Explain why Relative PPP is useful when comparing countries that base their price levels on different product baskets.

Question 8

Under Purchasing Power Parity,

Question 9

Assuming relative PPP, fill in the table below:

Question 10

Explain Purchasing Power Parity.

Question 11

Discuss the relationship between PPP and the Law of One Price.

Question 12

In order for the condition E_$/HK$ = P_US/P_HK to hold, what assumptions does the principle of purchasing power parity make?

A) Only that there are no transportation costs and restrictions on trade.
B) Only that the markets are perfectly competitive, i.e., P = MC.
C) The factors of production are identical between countries.
D) No arbitrage exists.
E) HK and US are perfectly competitive and there are no transportation costs or restrictions on trade.

Question 13

Which of the following statements is the most accurate?

A) Absolute PPP does not imply relative PPP.
B) Relative PPP implies absolute PPP.
C) There is no causality relation between the two.
D) Absolute PPP implies relative PPP.
E) Absolute PPP is inversely related to relative PPP.

Question 14

Which of the following statements is the most accurate?

A) Relative PPP may be valid even when absolute PPP is not, provided the factors causing deviations from absolute PPP are more or less stable over different commodities space.
B) Absolute PPP may be valid even when relative PPP is not, provided the factors causing deviations from relative PPP are more or less stable over time.
C) Relative PPP may be valid even when absolute PPP is not, provided the factors causing deviations from absolute PPP are more or less stable over time.
D) Relative PPP is not valid when absolute PPP is not.
E) Relative PPP is only valid when absolute PPP is valid, providing the factors causing deviations from relative PPP are more or less stable over time.

Question 15

Which of the following statements is the most accurate?

A) If PPP holds true, then the law of one price holds true for every commodity as long as the reference baskets used to reckon different countries' price levels are the same.
B) If the law of one price holds true for every commodity, PPP must hold automatically.
C) If the law of one price holds true for every commodity, PPP must automatically hold as long as the reference baskets used to reckon different countries' price levels are the same.
D) If the law of one price does not hold true for every commodity, PPP cannot be true as long as the reference baskets used to reckon different countries' price levels are the same.
E) If PPP holds true, then the law of one price must hold true automatically.

Question 16

Fill in the following table, assuming the law of one price prevails.

Question 17

Suppose Russia's inflation rate is 200% over one year but the inflation rate in Switzerland is only 2%. According to relative PPP, what should happen over the year to the Swiss franc's exchange rate against the Russian ruble?

Question 18

Which of the following statements is the most accurate?

A) In the long run, national price levels play a minor role in determining both interest rates and the relative prices at which countries' products are traded.
B) In the long run, national price levels play a key role only in determining interest rates.
C) In the long run, national price levels play a key role only in determining the relative prices at which countries' products are traded.
D) In the long run, national price levels play a key role in determining both interest rates and the relative prices at which countries' products are traded.
E) In the long run, national price levels play no role in determining interest rates and the relative prices at which countries' products are traded.

Question 19

Which of the following statements is the most accurate? In general,

A) the monetary approach to the exchange rate is a long run theory.
B) the monetary approach to the exchange rate is a short run theory.
C) the monetary approach to the exchange rate is both a short and long run theory.
D) the monetary approach to the exchange rate neither long run nor short run theory.
E) the monetary approach to the exchange rate is considered less practical than the law of one price.

Question 20

Under Purchasing Power Parity,

Question 21

Under PPP (and by the Fisher Effect), all else equal,

A) a rise in a country's expected inflation rate will eventually cause a more-than proportional rise in the interest rate that deposits of its currency offer in order to accommodate for the higher inflation.
B) a fall in a country's expected inflation rate will eventually cause an equal rise in the interest rate that deposits of its currency offer.
C) a rise in a country's expected inflation rate will eventually cause an equal rise in the interest rate that deposits of its currency offer.
D) a rise in a country's expected inflation rate will eventually cause a less than proportional rise in the interest rate that deposits of its currency offer to accommodate the rise in expected inflation.
E) a fall in a country's expected inflation rate will eventually cause an inversely proportional rise in the interest rate that deposits of its currency offer to accommodate the rise in expected inflation.

Question 22

To answer the following question, please refer to the figure below. Concentrating only at the upper right quadrant, discuss the foreign exchange market equilibrium.

Question 23

Discuss the effects of ongoing inflation based on the PPP theory.

Question 24

What is the Fisher Effect? Provide an example.

Question 25

Describe and explain the relationship between expected inflation rates in two countries and their interest rate differential according to the PPP theory.

Question 26

Under a flexible-price monetary approach to the exchange rate,

A) when the domestic money supply falls, the price level would eventually fall, increasing the interest rate.
B) when the domestic money supply falls, the price level would fall right away, causing a reduction in the interest rate.
C) when the domestic money supply falls, the price level would fall right away, causing an increase in the interest rate.
D) when the domestic money supply falls, the price level would eventually fall, keeping the interest rate constant.
E) when the domestic money supply falls, the price level would fall right away, keeping the interest rate constant.

Question 27

Who among the following list of people is an early 20th century economist from Yale University who wrote the book The Theory of Interest?

A) Gustav Cassel
B) Irving Fisher
C) David Ricardo
D) Paul Krugman
E) Israel Kirzner

Question 28

To answer the following question, please refer to the figure below. Concentrating only at the lower right quadrant, discuss the effects of a change in U.S. expected inflation.

Question 29

Present and explain the Fundamental Equation of the Monetary Approach.

Question 30

What are the predictions for the long run equilibrium of the Monetary Approach?

Question 31

If people expect relative PPP to hold,

A) the difference between the interest rates offered by dollar and euro deposits will equal the difference between the inflation rates expected, in the United States and Europe, respectively, over the relevant horizon.
B) the difference between the interest rates offered by dollar and euro deposits will equal the difference between the inflation rates expected in Europe and the United States, respectively.
C) the difference between the interest rates offered by dollar and euro deposits will equal the difference between the inflation rates expected, over the relevant horizon, in the United States and Europe, respectively, in the short run.
D) the difference between the interest rates offered by dollar and euro deposits will be above the difference between the inflation rates expected, over the relevant horizon, in the United States and Europe, respectively.
E) the difference between the interest rates offered by dollar and euro deposits will be below the difference between the inflation rates expected, over the relevant horizon, in the United States and Europe, respectively.

Question 32

To answer the following question, please refer to the figure below. Concentrating only at the lower left quadrant, discuss the relationship between the U.S. real money supply and the dollar/euro exchange rate, E_$/E.

Question 33

In the short run,

A) the interest rate can rise when the domestic money supply falls.
B) the interest rate can decrease when the domestic money supply falls.
C) the interest rate stays constant when the domestic money supply falls.
D) the interest rate rises in the same proportion as the domestic money supply falls.
E) the interest rate never rises when the domestic money supply falls.

Question 34

Which of the following statements is the most accurate? In general, under the monetary approach to the exchange rate,

A) the interest rate is not independent of the money supply growth rate in the short run.
B) the interest rate is independent of the money supply growth rate in the long run.
C) the interest rate is not independent of the money supply growth rate in the long run, but independent in the short run.
D) the interest rate is not independent of the money supply growth rate in the long run.
E) the interest rate is a factor of the money supply growth rate only in the short term.

Question 35

Under sticky prices,

A) an interest rate rise is associated with lower expected deflation and a long-run currency appreciation, so the currency appreciates immediately.
B) an interest rate rise is associated with higher expected inflation and a long-run currency appreciation, so the currency appreciates immediately.
C) an interest rate rise is associated with lower expected inflation and a long-run currency depreciation, so the currency appreciates immediately.
D) an interest rate rise is associated with lower expected inflation and a long-run currency depreciation, so the currency depreciates immediately.
E) an interest rate rise is associated with lower expected inflation and a long-run currency appreciation, so the currency appreciates immediately.

Question 36

Under sticky prices,

A) a fall in the money supply raises the interest rate to preserve money market equilibrium.
B) a fall in the money supply reduces the interest rate to preserve money market equilibrium.
C) a fall in the money supply keeps the interest rate intact to preserve money market equilibrium.
D) a fall in the money supply does not affect the interest rate in the short run, only in the long run.
E) a fall in the money supply raises the interest rate to preserve money market equilibrium in the long run.

Question 37

Explain why exchange rate model based on PPP is a long run theory.

Question 38

Which of the following statements is the most accurate? In general, under the monetary approach to the exchange rate,

A) while the short-run interest rate does not depend on the absolute level of the money supply, continuing growth in the money supply eventually will affect the interest rate.
B) while the long-run interest rate does depend on the absolute level of the money supply, continuing growth in the money supply do not affect the interest rate.
C) while the long-run interest rate does not depend on the absolute level of the money supply, continuing growth in the money supply eventually will affect the interest rate.
D) the long-run interest rate does not depend on the absolute level of the money supply, and thus continuing growth in the money supply will not affect the interest rate.
E) while the short-run interest rate does not depend on the absolute level of the money supply, continuing decline in the money supply eventually will not affect the interest rate.

Question 39

Under the monetary approach to the exchange rate,

A) a reduction in the money supply will cause immediate currency depreciation.
B) a rise in the money supply will cause currency depreciation.
C) a rise in the money supply will cause immediate currency appreciation.
D) a rise in the money supply will cause depreciation.
E) a rise in the money supply will cause immediate currency depreciation.

Question 40

Under the monetary approach to the exchange rate,

A) an interest rate decrease is associated with higher expected inflation and a currency that will be weaker on all future dates.
B) an interest rate increase is associated with higher expected deflation and a currency that will be weaker on all future dates.
C) an interest rate increase is associated with higher expected inflation and a currency that will be strengthened on all future dates.
D) an interest rate increase is associated with higher expected deflation and a currency that will be strengthened on all future dates.
E) an interest rate increase is associated with higher expected inflation and a currency that will be weaker on all future dates.

Question 41

Which of the following are theories meant to explain "Why Price Levels are Lower in Poorer Countries"?

A) only Bhagwati-Kravis-Lipsey
B) only Balassa-Samuelson
C) only Goldberg-Knetter
D) Bhagwati-Kravis-Lipsey and Balassa-Samuelson
E) Bhagwati-Kravis-Lipsey and Goldberg-Knetter

Question 42

Floating exchange rates

A) systematically lead to much larger but less frequent short-run deviations from the absolute PPP.
B) systematically lead to much larger and more frequent short-run deviations from the relative PPP.
C) systematically lead to much smaller and less frequent short-run deviations from the relative PPP.
D) systematically lead to much smaller but more frequent short-run deviations from the relative PPP.
E) systematically lead to much smaller and less frequent short-run deviations from the absolute PPP.

Question 43

How can long run values in the real exchange rate change?

Question 44

Which one of the following statements is the most accurate?

A) The purchasing power of any given country will increase in countries where the prices of non-tradable goods rise.
B) The purchasing power of any given country will fall in countries where the prices of non-tradable goods fall.
C) The purchasing power of any given country will fall in countries where the prices of non-tradable goods rise.
D) The purchasing power of any given country will remain constant in countries where the prices of non-tradable goods rise.
E) The purchasing power of any given country will fall in countries where the prices of non-tradable goods remain constant.

Question 45

What can explain the failure of relative PPP to hold in reality?

Question 46

Which of the following statements is the most accurate?

A) The law of one price does fare well in all recent studies.
B) The law of one price does fare well in many recent studies.
C) The law of one price sometimes fares well in recent studies.
D) The law of one price does not fare well in recent studies.
E) The law of one price has not been studied recently.

Question 47

Which of the following statements is the most accurate?

A) The prices of identical commodity baskets, when converted to a single currency, are the same across countries.
B) The prices of identical commodity baskets, when converted to a single currency, differ substantially across countries.
C) The prices of identical commodity baskets, when converted to a single currency, do not differ substantially across countries.
D) The prices of identical commodity baskets, when converted to a single currency, are often the same across countries.
E) The prices of identical commodity baskets, when converted to a single currency, are the same across countries more than 50% of the time.

Question 48

Which of the following statements is the most accurate about the Law of One Price on Scandinavian ferry lines?

A) Due to menu costs, the Law of One Price does not hold.
B) To avoid arbitrage opportunities, the Law of One Price must hold.
C) Transaction costs of exchanging currency allows the Law of One Price to fail.
D) Transportation costs between ferry lines leads to a violation of the Law of One Price.
E) The physical distance allowed the Law of One Price to hold.

Question 49

Which one of the following statements is the most accurate?

A) Departures from PPP are similar in both the short run and long run.
B) Departures from PPP are even greater in the long run than in the long run.
C) Departures from PPP are always greater in the short run than in the long run.
D) It is hard to tell whether departures from PPP are greater in the short run than in the long run.
E) Departures from PPP may often be greater in the short run than in the long run.

Question 50

Which one of the following statements is the most accurate?

A) Relative price changes could not lead to PPP violations even if trade were free and costless.
B) Relative price changes could lead to PPP violations only if trade were free and costless.
C) Relative price changes could lead to PPP violations even if trade were free and costless.
D) Price changes could lead to PPP violations even if trade were free and costless.
E) Price changes could not lead to PPP violations even if trade were free and costless.

Question 51

In practice,

A) changes in national price levels often tell us relatively little about exchange rate movements.
B) changes in national price levels raise the exchange rate.
C) changes in national price levels lower the exchange rate.
D) changes in national price levels often tell us about exchange rate movements.
E) changes in national price levels match identical changes in the exchange rate.

Question 52

Construct a table that will summarize the effects of money market and output market changes on the long-run nominal dollar/euro exchange rate

Question 53

Explain why price levels are lower in poorer countries.

Question 54

Is a depreciation of the dollar/euro exchange rate correlated with a decrease in the dollar return on U.S. deposits?

Question 55

The PPP theory fails in reality because

A) transport costs and restrictions on trade.
B) monopolistic or oligopolistic practices in goods markets.
C) the inflation data reported in different countries are based on different commodity baskets.
D) A, B, and C.
E) inflation rates are unrelated to money supply growth.

Question 56

Does the existence of non-tradable goods allow for deviations from Purchasing power Parity?

Question 57

What effect do non-tradable goods have on PPP?

Question 58

In February 2007, the world's cheapest Big Macs were sold in

A) the Philippines.
B) Russia.
C) Ukraine.
D) China.
E) the Czech Republic.

Question 59

Describe the chain of events leading to exchange rate determination for the following cases:
(a) An Increase in U.S. money supply
(d) Increase in growth rate of U.S. money supply
(c) Increase in world relative demand for U.S. products
(d) Increase in relative U.S. output supply

Question 60

Which of the following statements is the most accurate?

A) Relative PPP is not a reasonable approximation to the data.
B) Relative PPP is sometimes a reasonable approximation to the data but often performs poorly.
C) Relative PPP is sometimes a reasonable approximation to the data.
D) PPP is sometimes a reasonable approximation to the data.
E) PPP is sometimes a reasonable approximation to the data but usually performs poorly.

Question 61

An increase in the world relative demand for U.S. output causes

A) a short-run real depreciation of the dollar against the euro.
B) a long-run real appreciation of the dollar against the euro.
C) a long-run real depreciation of the dollar against the euro.
D) a short-run real appreciation of the euro against the dollar.
E) a long-run real appreciation of the euro against the dollar.

Question 62

Which of the following statements is most accurate?

A) The United States price level will place a relatively light weight on commodities produced and consumed in America, while the European price level will place a relatively heavy weight on commodities produced and consumed in Europe.
B) The United States price level will place a relatively light weight on commodities produced and consumed in America, and the European price level will place a relatively light weight on commodities produced and consumed in Europe.
C) The United States price level will place a relatively heavy weight on commodities produced and consumed in America, and the European price level will place a relatively heavy weight on commodities produced and consumed in Europe.
D) The United States price level will place a relatively heavy weight on commodities produced and consumed in Europe, and the European price level will place a relatively heavy weight on commodities produced and consumed in America.
E) The United States price level will place a relatively light weight on commodities produced and consumed in Europe, and the European price level will place a relatively heavy weight on commodities produced and consumed in America.

Question 63

Discuss the different effects on the domestic interest rates when prices are assumed flexible and when they are assumed to be sticky.

Question 64

What is the real exchange rate between the dollar and the euro equal to?

Question 65

Which of the following statements is most accurate?

A) In the money market, an increase in U.S. money supply level leads to a proportional increase in the long-run nominal dollar/euro exchange rate.
B) In the money market, an increase in European money supply level leads to a proportional increase in the long-run nominal dollar/euro exchange rate.
C) In the money market, an increase in U.S. money supply growth rate leads to a decrease in the long-run nominal dollar/euro exchange rate.
D) In the money market, an increase in European money supply growth leads to an increase in the long-run nominal dollar/euro exchange rate.
E) In the money market, an increase in U.S. money supply level leads to a proportional decrease in the long-run nominal dollar/euro exchange rate.

Question 66

What is the real interest rate parity condition?

Question 67

The expected rate of change in the nominal dollar/euro exchange rate is best described as

A) the expected rate of change in the real dollar/euro exchange rate minus the U.S.-Europe expected inflation difference.
B) the expected rate of change in the real dollar/euro exchange rate plus the U.S.-Europe real interest rate difference.
C) the expected rate of change in the real dollar/euro exchange rate plus the U.S.-Europe expected inflation difference.
D) the expected rate of change in the real dollar/euro exchange rate minus the U.S.-Europe real interest rate difference.
E) the expected rate of change in the real dollar/euro exchange rate plus the European expected inflation.

Question 68

The expected real interest rate (r^e) in terms of the nominal interest rate (R) and the expected inflation rate (π^e) is given by

Question 69

When the domestic money prices of goods are held constant

A) a nominal dollar appreciation makes U.S. goods cheaper compared with foreign goods.
B) a nominal dollar depreciation makes U.S. goods less appealing in foreign markets.
C) a nominal dollar appreciation does not affect the prices of U.S. goods.
D) a nominal dollar depreciation makes U.S. goods more expensive compared with foreign goods.
E) a nominal dollar depreciation makes U.S. goods cheaper compared with foreign goods and a nominal dollar appreciation makes U.S. goods more expensive compared with foreign goods.

Question 70

The difference between nominal and real interest rates is that

A) nominal interest rates are measured in terms of a country's output, while real interest rates are measured in monetary terms.
B) nominal interest rates are measured in monetary terms, while real interest rates are measured in terms of a country's output.
C) nominal interest rates can fluctuate, while real interest rates always remain fixed.
D) real interest rates can fluctuate, while nominal interest rates always remain fixed.
E) real interest rates are the same in every country, while nominal interest rates are different for every country.

Question 71

When the nominal dollar interest rate ________, money demand will ________, and the general price level will ________.

A) increases; decrease; increase
B) increases; increase; increase
C) increases; decrease; decrease
D) increases; increase; decrease
E) decreases; increase; increase

Question 72

In the long run

A) exchange rates obey relative PPP when all disturbances occur in the output markets.
B) exchange rates obey absolute PPP when all disturbances occur in the output markets.
C) exchange rates are unlikely to obey relative PPP when all disturbances occur in the output markets.
D) exchange rates are unlikely to obey relative PPP when all disturbances are monetary in nature.
E) exchange rates obey absolute PPP when all disturbances are monetary in nature.

Question 73

Interest rate differences between countries depend on

A) differences in expected inflation, but not on expected changes in the real exchange rate.
B) differences in expected changes in the real exchange rate, but not on expected inflation.
C) neither differences in expected inflation, nor on expected changes in the real exchange rate.
D) differences in expected inflation and nothing else.
E) differences in expected inflation, and on expected changes in the real exchange rate.

Question 74

Which of the following statements is most accurate?

A) In the output market, an increase in demand for U.S. output leads to an increase in the long-run nominal dollar/euro exchange rate.
B) In the output market, an increase in the demand for European output leads to an increase in the long-run nominal dollar/euro exchange rate.
C) In the output market, a decrease in demand for U.S. output leads to a decrease in the long-run nominal dollar/euro exchange rate.
D) In the output market, an increase in the demand for European output leads to a decrease in the long-run nominal dollar/euro exchange rate.
E) In the output market, an increase in the demand for European output leads to an increase in the long-run nominal euro/dollar exchange rate.

Question 75

The monetary approach to interest rates assumes that the prices of goods are ________, which implies that a country's currency will ________, when nominal interest rates ________ because of ________ expected future inflation.

A) perfectly flexible; depreciate; increase; higher
B) perfectly flexible; appreciate; increase; higher
C) immutable; depreciate; increase; higher
D) immutable; appreciate; decrease; higher
E) absolutely inflexible; depreciate; decrease; higher

Question 76

Define the concept of the real exchange rate and explain how it differs from the nominal exchange rate.

Question 77

Which of the following statements is most accurate?

A) A relative expansion of U.S. output causes a long-run depreciation of the dollar against the euro, while a relative expansion of European output causes a long-run real appreciation of the dollar against the euro.
B) A relative decline of U.S. output causes a long-run depreciation of the dollar against the euro, while a relative expansion of European output causes a long-run real appreciation of the dollar against the euro.
C) A relative expansion of U.S. output causes a long-run appreciation of the dollar against the euro, while a relative expansion of European output causes a long-run real depreciation of the dollar against the euro.
D) A relative expansion of U.S. output causes a long-run depreciation of the dollar against the euro, while a relative decline of European output causes a long-run real appreciation of the dollar against the euro.
E) A relative decline of U.S. output causes a long-run depreciation of the dollar against the euro, while a relative decline of European output causes a long-run real appreciation of the dollar against the euro.

Question 78

Discuss why the empirical support for PPP and the law of one price is weak in recent data.

Question 79

What are the predictions of the PPP theory with regards to the real exchange rates?

Question 80

When all variables start out at their long-run equilibrium levels, the most important determinant of long-run swings in nominal exchange rates is

A) a shift in relative money supply levels.
B) a shift in relative money supply growth rates.
C) a change in relative output demand.
D) a change in relative output supply.
E) a change in relative inflation rates.