Question 1

If the price of a Toyota Camry is Y2,000,000 and the price of a Ford Fusion is $20,000, according to the law of one price, the exchange rate between the yen and the dollar should be:

Accepted Answer

The law of one price states that identical goods should sell for the same price when expressed in a common currency. If a Toyota Camry costs Y2,000,000 and a Ford Fusion costs $20,000, the exchange rate should be Y100 = $1 to equalize the prices.

Question 2

Though useful, purchasing power parity does not completely explain long-run movements in exchange rates due to

Accepted Answer

Purchasing power parity only takes into account the price of tradable goods and services, therefore it cannot completely explain long-run movements in exchange rates due to factors such as the presence of nontradeable goods, changes in the real exchange rate, and differentiated products.

Question 3

What would happen to the value of the dollar if prices in the U.S. increased more rapidly relative to prices in other countries?

Accepted Answer

The answer of What would happen to the value of...

Question 4

When deciding between domestic and foreign financial investments, investors typically consider

Accepted Answer

When deciding between domestic and foreign financial investments, investors typically consider domestic and foreign interest rates and expected changes in the exchange rate. Interest rates impact the return on the investment, and changes in exchange rates can impact the value of the investment when converted back to the investor's home currency.

Question 5

If U.S. inflation is 2%, Japanese inflation is 1%, and Mexican inflation is 3%, which of the following is true according to the theory of purchasing power parity?

Accepted Answer

According to purchasing power parity, the currency of a country with higher inflation should depreciate relative to the currency of a country with lower inflation. Since U.S. inflation is higher than Japanese inflation, the dollar should depreciate by 1% against the yen. Since U.S. inflation is lower than Mexican inflation, the dollar should appreciate by 1% against the peso.

Question 6

Suppose the exchange rate is 10 pesos per dollar and you use $1000 to purchase a one-year Mexican bond that pays 10% interest. Next year, the exchange rate is 11 pesos per dollar. Assuming you convert your funds back to U.S. dollars, how much money will you have in one year?

Accepted Answer

Initially, you convert $1000 to pesos at a rate of 10 pesos per dollar, giving you 10,000 pesos. After one year, the bond pays 10% interest, so you have 11,000 pesos. When you convert back to dollars at the new exchange rate of 11 pesos per dollar, you get $1000, as 11,000 pesos / 11 pesos per dollar = $1000.

Question 7

The nominal interest rate parity condition states that

Accepted Answer

The nominal interest rate parity condition states that when two assets have identical characteristics, such as risk, liquidity, and information, their nominal returns must also be identical. This is because investors should not be willing to hold an asset with a lower nominal return when an identical asset is available with a higher nominal return. However, this does not imply that real returns will be identical as differences in inflation rates will affect the purchasing power of the returns.

Question 8

The process by which identical products that are tradeable converge to the same price is called

Accepted Answer

Arbitrage refers to the process of buying and selling identical products in different markets in order to make a profit from price discrepancies. Through this process, the prices of these products eventually converge to the same level, eliminating the possibility for arbitrage opportunities. Hedging, speculation, and risk aversion are all related to managing financial risks but do not necessarily result in the convergence of prices for identical products.

Question 9

We would not expect a Japanese financial asset and a U.S. financial asset with identical risk, liquidity, and information characteristics to have different expected returns because

Accepted Answer

In an efficient financial market, traders would take advantage of any difference in expected returns between two assets with identical risk, liquidity, and information characteristics. They would buy the asset with the higher expected yield and sell the asset with the lower expected yield until the yields were brought into equality, eliminating any difference in expected returns. Therefore, we would not expect a Japanese financial asset and a U.S. financial asset with identical risk, liquidity, and information characteristics to have different expected returns.

Question 10

If you are indifferent between investing $1000 for one year in a U.S. Treasury security that has an interest rate of 5% or in a Canadian government security that has an interest rate of 8%, you must be expecting

Accepted Answer

The answer of If you are indifferent between investing $1000...

Question 11

A quota refers to:

Accepted Answer

A quota is a limit on the amount of a good that can be imported. It is often used as a protectionist trade policy to limit foreign competition and protect domestic industries.

Question 12

Purchasing power parity's assumption that the real exchange is constant

Accepted Answer

The assumption that the real exchange rate is constant is not reasonable in the long run because there are various factors that affect the exchange rate such as inflation rates, trade policies, and political events. Therefore, purchasing power parity's assumption may not always hold true in practice.

Question 13

Which of the following is NOT an implication of the theory of purchasing power parity?

Accepted Answer

The theory of purchasing power parity implies that a country with a higher inflation rate should see a depreciation, not an appreciation, of its currency. This is because higher inflation reduces the value of money, making it necessary to adjust the exchange rate to maintain equal purchasing power.

Question 14

If the German interest rate is 4% and the U.S. interest rate is 5%, what is the expected change in the value of the dollar in terms of the euro?

Accepted Answer

According to the interest rate parity theory, if the U.S. interest rate is higher than the German interest rate, the dollar is expected to depreciate against the euro, making the correct answer -1%.

Question 15

If the nominal interest rate parity condition is not met,

Accepted Answer

The nominal interest rate parity condition, when not met, implies that the return from holding domestic assets could either be greater or less than the expected return from holding foreign assets, depending on the specific deviation from parity. This condition does not directly predict the direction of the discrepancy, only that a discrepancy exists.

Question 16

Suppose that you expect during the next year the dollar will appreciate against the pound from 0.5 pound to the dollar to 0.75 pound to the dollar. How much will you expect to make on an investment of $10,000 in British government securities that will mature in one year and pay interest of 8%?

Accepted Answer

First, we need to calculate how much the investment is worth in pounds when we make it. Since the exchange rate is 0.5 pound to the dollar, $10,000 is worth 5,000 pounds.

Next, we calculate the interest earned on the investment in pounds, which is 8% of 5,000 pounds, or 400 pounds.

Finally, we need to convert the investment and interest earned back into dollars using the new exchange rate of 0.75 pound to the dollar. The investment is now worth 5,000 pounds * 0.75 pound/dollar = $3,750. The interest earned is worth 400 pounds * 0.75 pound/dollar = $300.

The total value of the investment at maturity is $4,050 ($3,750 + $300). This represents a return of 4.5% ($4,050 / $10,000). However, since we expect the dollar to appreciate against the pound, the return in dollars will be lower than 4.5%.

To calculate the expected return in dollars, we take the difference between the old and new exchange rates, and divide by the old exchange rate:

(0.75 - 0.5) / 0.5 = 0.5, or 50%.

So we expect the dollar to appreciate by 50% against the pound. Therefore, the expected return on our investment in dollars is 4.5% minus 50%, or -45.5%.

However, the question is asking for the expected profit, not the expected return. To calculate this, we take the total value of the investment at maturity and subtract the initial investment:

$4,050 - $10,000 = -$5,950

This represents a loss of $5,950 on the investment, or -59.5% of the initial investment.

Therefore, the correct answer is B, -59.5%.

Question 17

The demand for U.S. dollars represents:

Accepted Answer

The demand for U.S. dollars represents the demand for U.S. goods and financial assets by households and firms outside the United States. This is because many international transactions are conducted in U.S. dollars and therefore, they need to acquire U.S. dollars to engage in trade and investment activities with the United States.

Question 18

What real-world complications keep purchasing power parity from being a complete explanation of exchange rates ?

Accepted Answer

The answer of What real-world complications keep purchasing power parity...

Question 19

International capital mobility refers to

Accepted Answer

International capital mobility refers to the ability of investors to move their capital among different countries' financial markets. This includes the ease with which funds can be transferred without having to be converted into a foreign currency.

Question 20

What would happen in the foreign exchange market if the European Central Bank raises European interest rates?

Accepted Answer

When the European Central Bank raises European interest rates, it makes holding euros more attractive due to higher returns on investments denominated in euros. This increased demand for euros strengthens the euro relative to other currencies, including the dollar, leading to a decline in the value of the dollar as investors sell dollars to buy euros.

Quiz 8: The Market for Foreign Exchange