Question 1

The absolute purchasing power parity condition cannot be satisfied if the law of one price does not hold.

Accepted Answer

The absolute purchasing power parity condition requires that the same basket of goods in two different countries should have the same price when expressed in a common currency. This is only possible if the law of one price holds, which states that identical goods in different locations should have the same price. Therefore, if the law of one price does not hold, the absolute purchasing power parity condition cannot be satisfied.

Question 2

The fundamental concept related to the law of one price is:

Accepted Answer

The law of one price states that the same product, when traded in different markets, must have the same price in both markets after accounting for transportation, taxes, and other costs. This is because if the price differed between the markets, there would be an opportunity for arbitrage, where traders could profit by buying the product in the cheaper market and selling it in the more expensive market. Therefore, arbitrage is the fundamental concept related to the law of one price.

Question 3

Past information is relevant:

Accepted Answer

Both adaptive and rational expectations take into account past information to some extent. Adaptive expectations rely solely on past information, while rational expectations take into account past information as well as other factors such as current events, economic trends, and future expectations. Therefore, option D is the correct choice.

Question 4

The forward exchange rate:

Accepted Answer

The forward exchange rate is a rate that is determined today but applies to a currency exchange at a future date. This allows for businesses and individuals to hedge against currency fluctuations and plan ahead for transactions that will take place in the future.

Question 5

The factor that can account for failure of the forward exchange rate to equal currency traders- expectation of the future spot exchange rate is:

Accepted Answer

The failure of the forward exchange rate to equal currency traders' expectation of the future spot exchange rate can be attributed to the presence of a risk premium. Traders may demand a higher forward exchange rate to compensate for the perceived risk associated with fluctuations in the exchange rate. This risk can arise from various factors such as political instability, economic uncertainty or events that may affect the demand and supply of the currencies in the future.

Question 6

If the purchasing power parity and uncovered interest parity conditions simultaneously hold true, then it is unambiguously true that:

Accepted Answer

If both conditions hold true, it means that exchange rates reflect the true value of currencies and real interest rates in different countries are equal. Therefore, there will be no opportunities for arbitrage in financial markets.

Question 7

If the expected proportionate change in the nominal exchange rate, measured in units of domestic currency per unit of foreign currency, is 2 percent and the domestic interest rate is 6 percent, then according to the uncovered interest parity condition, the foreign interest rate should be equal to:

Accepted Answer

According to the uncovered interest parity condition, the expected proportionate change in the nominal exchange rate equals the difference between the foreign and domestic interest rates. Therefore, we can solve for the foreign interest rate as follows:

Expected change in exchange rate = Foreign interest rate - Domestic interest rate
2% = Foreign interest rate - 6%
Foreign interest rate = 6% + 2% = 8%

Therefore, the foreign interest rate should be 8%. The correct answer is choice (B).

Question 8

In the presence of a risk premium, which of the following conditions fail to hold true? (I) Uncovered interest parity. (II) Real interest parity. (III) Foreign exchange market efficiency.

Accepted Answer

The answer of In the presence of a risk premium,...

Question 9

Real interest parity arises from combining: (I) Relative purchasing power parity. (II) Uncovered interest parity. (III) Covered interest parity.

Accepted Answer

Real interest parity combines relative purchasing power parity and uncovered interest parity, as it involves the relationship between real interest rates and expected changes in exchange rates, which are influenced by inflation differentials and interest rate differentials without forward contracts.

Question 10

If the foreign currency is anticipated to appreci:ate with respect to the domestic currency and the relative purchasing power parity condition is satisfied, then

Accepted Answer

When the foreign currency is expected to appreciate with respect to the domestic currency and the relative purchasing power parity condition is satisfied, people expect higher inflation in the domestic nation than in the foreign nation. This is because the relative purchasing power parity condition states that, in the long run, exchange rates will adjust to equalize the cost of a basket of goods and services between two countries. Therefore, if the foreign currency is expected to appreciate, it means that the cost of goods and services in the foreign nation will decrease, indicating lower inflation in the foreign nation compared to the domestic nation.

Question 11

If the nominal exchange is measured in units of domestic currency per unit of foreign currency, then the real exchange rate equals:

Accepted Answer

The real exchange rate is calculated by multiplying the nominal exchange rate with the ratio of the foreign price level to the domestic price level. This adjusts the nominal rate by the price levels, reflecting the real value of currencies.

Question 12

If deviations from real interest parity increase over time, then this is evidence of greater integration of international goods and financial markets.

Accepted Answer

The answer of If deviations from real interest parity increase...

Question 13

If absolute purchasing power parity holds true, then the real exchange rate equals the nominal exchange rate.

Accepted Answer

Absolute purchasing power parity implies that the purchasing power of two currencies is the same when adjusted for the exchange rate, but the real exchange rate is calculated by adjusting the nominal exchange rate for differences in price levels between countries, not equated to it.

Question 14

If absolute purchasing power parity holds true and the ratio of the domestic price level to the foreign price level is greater than the actual nominal exchange rate, then the domestic currency is currently overvalued.

Accepted Answer

If the ratio of the domestic price level to the foreign price level is greater than the actual nominal exchange rate, this means that the domestic currency is able to buy more goods relative to the foreign currency than the nominal exchange rate suggests. This indicates that the domestic currency is overvalued and will likely depreciate to restore equilibrium.

Question 15

If the difference between the domestic inflation rate and the foreign inflation rate exceeds the percentage depreciation in the domestic currency, then relative purchasing power parity holds true.

Accepted Answer

Relative Purchasing Power Parity (PPP) holds when the rate of depreciation of the domestic currency is equal to the difference between the domestic and foreign inflation rates, not when it exceeds this difference.

Question 16

If people form expectations adaptively, then their predictions must be correct on average.

Accepted Answer

Adaptive expectations involve adjusting predictions based on past errors, but this does not guarantee that future predictions will be correct on average, as it relies on past data which may not accurately predict future events.

Question 17

If foreign exchange markets are efficient, then the relative purchasing power parity condition must hold true.

Accepted Answer

The efficiency of foreign exchange markets does not necessarily imply that relative purchasing power parity (PPP) holds true, as market efficiency relates to the incorporation of information into prices, while PPP is a theory about the long-term equilibrium exchange rate based on price levels.

Question 18

The rational expectations hypothesis suggests that people form expectations based on all available past and current information and on a basic understanding of how markets function.

Accepted Answer

The rational expectations hypothesis is based on the assumption that individuals form expectations based on all available information and a basic understanding of how markets work. This hypothesis is commonly used in economic models to predict future outcomes.

Question 19

If the foreign exchange market efficiency condition is satisfied, then the equilibrium spot and forward exchange adjust to reflect all available information, in which case the forward premium is equal to the expected rate of currency depreciation plus any risk premium.

Accepted Answer

If the foreign exchange market is efficient, then all available information is already incorporated into the exchange rates. This means that the forward premium should equal the expected rate of currency depreciation plus any risk premium.

Question 20

The real interest rate is a rate of return in current-dollar terms that is equal to the nominal interest rate plus the anticipated rate of inflation.

Accepted Answer

The real interest rate is actually equal to the nominal interest rate minus the anticipated rate of inflation, not plus.

Quiz 8: The Power of Arbitrage: Purchasing Power and Interest Rate Parities