Question 1

Which of the following is illustrated by the Big Mac Index published by The Economist?

Accepted Answer

Every year, the news magazine The Economist publishes its own version of the purchasing power parity (PPP) theorem, which it refers to as the "Big Mac Index." According to The Economist, comparing a country's actual exchange rate with the one predicted by the PPP theorem based on relative prices of Big Macs is a test of whether a currency is undervalued or not.

Question 2

In countries where inflation is expected to be high, interest rates also will be high, because investors want compensation for the decline in the value of their money. This relationship is referred to as the:

Accepted Answer

Economic theory tells us that interest rates reflect expectations about likely future inflation rates. In countries where inflation is expected to be high, interest rates also will be high, because investors want compensation for the decline in the value of their money. This relationship was first formalized by economist Irvin Fisher and is referred to as the Fisher effect.

Question 3

The purchasing power parity (PPP) theory tells us that a country with a high inflation rate will see:

Accepted Answer

When the growth in a country's money supply is faster than the growth in its output, price inflation is fueled. The purchasing power parity (PPP) theory tells us that a country with a high inflation rate will see depreciation in its currency exchange rate.

Question 4

Which of the following is a reason for the failure of the purchasing power parity (PPP) theory to predict exchange rates accurately?

Accepted Answer

Several factors may explain the failure of purchasing power parity (PPP) theory to predict exchange rates more accurately. Purchasing power parity theory assumes away transportation costs and barriers to trade. It also assumes that the markets are relatively efficient. In practice, these factors are significant and they tend to create significant price differentials between countries. Transportation costs are certainly not trivial for many goods.

Question 5

The nominal interest rate is 9 percent in Brazil and 6 percent in Japan. Applying the international Fisher effect, the Brazilian real should:

Accepted Answer

The international Fisher effect states that for any two countries, the spot exchange rate should change in an equal amount but in the opposite direction to the difference in nominal interest rates between the two countries.

Question 6

If a country's government does not control the rate of growth in money supply:

Accepted Answer

Government policy determines whether the rate of growth in a country's money supply is greater than the rate of growth in output. If the government seems to lack the political will to control the rate of growth in money supply, the future inflation rate may be high, which is likely to cause its currency to depreciate.

Question 7

Which of the following is true of the purchasing power parity (PPP) theory?

Accepted Answer

A less extreme version of the purchasing power parity (PPP) theory states that given relatively efficient markets-that is, markets in which few impediments to international trade exist-the price of a "basket of goods" should be roughly equivalent in each country.

Question 8

The failure to find a strong link between relative inflation rates and exchange rate movements has been referred to as the:

Accepted Answer

The failure to find a strong link between relative inflation rates and exchange rate movements has been referred to as the purchasing power parity puzzle. Several factors may explain the failure of purchasing power parity theory to predict exchange rates more accurately.

Question 9

The Fisher effect states that:

Accepted Answer

Economic theory tells us that interest rates reflect expectations about likely future inflation rates. In countries where inflation is expected to be high, interest rates also will be high, because investors want compensation for the decline in the value of their money. This relationship was first formalized by economist Irvin Fisher and is referred to as the Fisher effect. The Fisher effect states that a country's "nominal" interest rate (i) is the sum of the required "real" rate of interest (r) and the expected rate of inflation over the period for which the funds are to be lent (I).

Question 10

According to the Fisher effect, if the "real" rate of interest in a country is 4 percent and the expected annual inflation is 9 percent, what would the "nominal" interest rate be?

Accepted Answer

The Fisher effect states that a country's "nominal" interest rate (i) is the sum of the required "real" rate of interest (r) and the expected rate of inflation over the period for which the funds are to be lent (I).i = r + I, i.e., 4% + 9% = 13%

Question 11

Which of the following is true when a government is strongly committed to controlling the rate of growth in money?

Accepted Answer

Government policy determines whether the rate of growth in a country's money supply is greater than the rate of growth in output. If the government seems committed to controlling the rate of growth in money supply, the country's future inflation rate may be low (even if the current rate is high) and its currency should not depreciate too much on the foreign exchange market.

Question 12

During inflation, an increase in the amount of currency available leads to:

Accepted Answer

A way of looking at inflation is that an increase in a country's money supply, which increases the amount of currency available, changes the relative demand-and-supply conditions in the foreign exchange market.

Question 13

Which of the following weakens the link between relative price changes and changes in exchange rates predicted by purchasing power parity (PPP) theory by violating the assumption of efficient markets?

Accepted Answer

Governments routinely intervene in international trade, creating tariff and nontariff barriers to cross-border trade. Barriers to trade limit the ability of traders to use arbitrage to equalize prices for the same product in different countries, which is required for the law of one price to hold. Government intervention in cross-border trade, by violating the assumption of efficient markets, weakens the link between relative price changes and changes in exchange rates predicted by the purchasing power parity (PPP) theory.

Question 14

Which of the following is a drawback of the purchasing power parity theory?

Accepted Answer

Purchasing power parity (PPP) theory predicts that exchange rates are determined by relative prices and that changes in relative prices will result in a change in exchange rates. While PPP theory seems to yield relatively accurate predictions in the long run, it does not appear to be a strong predictor of short-run movements in exchange rates covering time spans of five years or less.

Question 15

Which of the following is true of inflation?

Accepted Answer

Inflation is a monetary phenomenon. It occurs when the quantity of money in circulation rises faster than the stock of goods and services-that is, when the money supply increases faster than output increases.

Question 16

Which of the following states that for any two countries, the spot exchange rate should change in an equal amount but in the opposite direction to the difference in nominal interest rates between the two countries?

Accepted Answer

The international Fisher effect states that for any two countries, the spot exchange rate should change in an equal amount but in the opposite direction to the difference in nominal interest rates between the two countries.

Question 17

Which of the following occurs when a government increases the money supply?

Accepted Answer

A government increasing the money supply is analogous to giving people more money. An increase in the money supply makes it easier for banks to borrow from the government and for individuals and companies to borrow from banks. The resulting increase in credit causes increases in demand for goods and services.

Question 18

The purchasing power parity (PPP) theory best predicts exchange rate changes for countries with:

Accepted Answer

Purchasing power parity (PPP) theory predicts that exchange rates are determined by relative prices and that changes in relative prices will result in a change in exchange rates. The theory seems to best predict exchange rate changes for countries with high rates of inflation and underdeveloped capital markets.

Question 19

When dominant enterprises in an industry exercise a degree of pricing power, setting different prices in different markets to reflect varying demand conditions, it is referred to as:

Accepted Answer

Purchasing power parity (PPP) theory may not hold if many national markets are dominated by a handful of multinational enterprises that have sufficient market power to be able to exercise some influence over prices, control distribution channels, and differentiate their product offerings between nations. When dominant enterprises in an industry exercise pricing power to set different prices in different markets to reflect varying demand conditions, it is referred to as price discrimination.

Question 20

Which of the following is a way in which an enterprise with some market power might limit arbitrage so that their price discrimination policy works?

Accepted Answer

For price discrimination to work, arbitrage must be limited. According to this argument, enterprises with some market power may be able to control distribution channels and therefore limit the unauthorized resale (arbitrage) of products purchased in another national market. They may also be able to limit resale (arbitrage) by differentiating otherwise identical products among nations along some line, such as design or packaging.

Quiz 10: The Foreign Exchange Market

Which of the following is illustrated by the Big Mac Index published by The Economist?

In countries where inflation is expected to be high, interest rates also will be high, because investors want compensation for the decline in the value of their money. This relationship is referred to as the:

The purchasing power parity (PPP) theory tells us that a country with a high inflation rate will see:

Which of the following is a reason for the failure of the purchasing power parity (PPP) theory to predict exchange rates accurately?

The nominal interest rate is 9 percent in Brazil and 6 percent in Japan. Applying the international Fisher effect, the Brazilian real should:

If a country's government does not control the rate of growth in money supply:

Which of the following is true of the purchasing power parity (PPP) theory?

The failure to find a strong link between relative inflation rates and exchange rate movements has been referred to as the:

The Fisher effect states that:

According to the Fisher effect, if the "real" rate of interest in a country is 4 percent and the expected annual inflation is 9 percent, what would the "nominal" interest rate be?

Which of the following is true when a government is strongly committed to controlling the rate of growth in money?

During inflation, an increase in the amount of currency available leads to:

Which of the following weakens the link between relative price changes and changes in exchange rates predicted by purchasing power parity (PPP) theory by violating the assumption of efficient markets?

Which of the following is a drawback of the purchasing power parity theory?

Which of the following is true of inflation?

Which of the following states that for any two countries, the spot exchange rate should change in an equal amount but in the opposite direction to the difference in nominal interest rates between the two countries?

Which of the following occurs when a government increases the money supply?

The purchasing power parity (PPP) theory best predicts exchange rate changes for countries with:

When dominant enterprises in an industry exercise a degree of pricing power, setting different prices in different markets to reflect varying demand conditions, it is referred to as:

Which of the following is a way in which an enterprise with some market power might limit arbitrage so that their price discrimination policy works?