Question 1

If relative PPP held, then the real exchange rate must be equal to one.

Accepted Answer

If relative PPP held, then the real exchange rate must be equal to a constant number.

Question 2

Is PPP a theory of exchange rate determination? Explain why or why not?

Accepted Answer

The answer of Is PPP a theory of exchange rate...

Question 3

The empirical data indicate that in the short run exchange rates are much more variable than inflation differentials.

Accepted Answer

Short-term fluctuations in exchange rates are often driven by speculative market forces and can result in large swings, whereas inflation differentials tend to change more gradually over time.

Question 4

What is the difference between endogenous and exogenous variables? In the equilibrium condition of PPP, which variables are endogenous and which are exogenous?

Accepted Answer

The answer of What is the difference between endogenous and...

Question 5

We expect that in the long run, exchange rate movements will largely reflect inflation differentials.

Accepted Answer

Inflation plays a major role in determining the value of a currency, so exchange rate movements are likely to be closely connected to inflation. Over time, currencies with higher rates of inflation are likely to depreciate relative to currencies with lower rates of inflation. Therefore, inflation differentials are an important factor in determining exchange rate movements in the long run.

Question 6

Empirical studies find that exchange rates are much more variable than inflation differentials. How can we explain this empirical result?

Accepted Answer

The answer of Empirical studies find that exchange rates are...

Question 7

The higher the inflation differential between countries, the less likely it is that relative PPP will hold.

Accepted Answer

The answer of The higher the inflation differential between countries,...

Question 8

Studies of PPP covering many years will be more likely to yield evidence of PPP than studies based on short-run data.

Accepted Answer

Studies of PPP cover long-run equilibrium relationships between exchange rates and prices, and short-run fluctuations can mask these relationships. Therefore, longer time periods are more likely to provide evidence of PPP.

Question 9

If the law of one price holds for a single good, then absolute PPP measured with price indexes will also hold.

Accepted Answer

Since consumers in different countries consume different goods, price indexes are not directly comparable internationally. Thus using price indexes to measure PPP creates problems and causes deviations from PPP.

Question 10

Is relative PPP a useful equilibrium concept for describing general trends in exchange rates? Under what kinds of circumstances would the concepts of PPP be best applied?

Accepted Answer

The answer of Is relative PPP a useful equilibrium concept...

Question 11

The only reason that exchange rates change is because overall price levels in the countries change.

Accepted Answer

Exchange rates can change for various reasons such as changes in interest rates, changes in political and economic conditions, and changes in market sentiment, in addition to changes in overall price levels.

Question 12

If absolute PPP holds, then the real exchange rate must equal 1.

Accepted Answer

If absolute PPP holds, then the price of identical goods in different countries should be the same when converted to a common currency. Therefore, the real exchange rate would be equal to 1, as there would be no difference in the purchasing power of the currencies.

Question 13

Endogenous variables tend to be less volatile than exogenous ones.

Accepted Answer

Endogenous variables are determined within the model and can be highly volatile as they respond to changes in other variables within the system, whereas exogenous variables are external and do not change in response to the model's dynamics, making them less volatile in the context of the model's behavior.

Question 14

According to The Economist magazine's Big Mac index, one of the most overvalued currencies as of July 2008 was the Norwegian kroner. Which of the following is a likely implication of that fact?

Accepted Answer

According to the Big Mac index, the Norwegian kroner is overvalued, which means it takes more kroner to buy a Big Mac in Norway compared to the U.S. Therefore, goods and services are likely to be more expensive in Norway than in the U.S.

Question 15

If absolute PPP holds, then relative PPP will also hold.

Accepted Answer

If absolute PPP holds, it means that the exchange rate between two countries is completely determined by the relative prices of the same basket of goods in each country. Therefore, if the price level of one country rises relative to another, its currency will depreciate accordingly to maintain the PPP equilibrium. This in turn satisfies the condition for relative PPP, which states that changes in the exchange rate between two countries should reflect differences in their inflation rates.

Question 16

Suppose a year ago the exchange rate between Mexican pesos and dollars was 13.5 pesos per dollar, and that according to relative PPP the exchange rate was in equilibrium. Furthermore, assume that since then, Mexican inflation has been 12 percent while the U.S. inflation has been 3 percent. If according to relative PPP the peso is now said to be overvalued, what is a possible exchange rate consistent with this assertion?

Accepted Answer

The answer of Suppose a year ago the exchange rate...

Question 17

PPP is a theory of exchange rate determination.

Accepted Answer

The answer of PPP is a theory of exchange rate...

Question 18

The more homogeneous goods are, the more we expect the law of one price not to hold.

Accepted Answer

The law of one price is more likely to hold for homogeneous goods because they are identical and can be easily substituted, leading to price equalization across markets.

Question 19

PPP holds better for low-inflation countries.

Accepted Answer

Opposite, in high-inflation countries changes in exchange rates are highly correlated with inflation differentials because the sheer magnitude of inflation overwhelms the relative price effects.

Quiz 14: Prices and Exchange Rates: Purchasing Power Parity