Question 1

Assume a two-country world: Country A and Country B. Which of the following is correct about purchasing power parity (PPP) as related to these two countries?

Accepted Answer

Purchasing power parity (PPP) theory suggests that in the long run, exchange rates will adjust so that an identical good in two different countries will have the same price when expressed in a common currency. If Country A's inflation rate is higher than Country B's, it means prices are rising faster in Country A. To maintain PPP, Country A's currency must weaken relative to Country B's currency to equalize the prices of goods between the two countries.

Question 2

If interest rates on the euro are consistently below U.S. interest rates, then for the international Fisher effect (IFE) to hold:

Accepted Answer

A

Question 3

The international Fisher effect (IFE) suggests that:

Accepted Answer

The international Fisher effect posits that currencies with higher interest rates will depreciate because the higher rates reflect expected inflation.

Question 4

Assume U.S. and Swiss investors require a real rate of return of 3%. Assume the nominal U.S. interest rate is 6% and the nominal Swiss rate is 4%. According to the international Fisher effect, the franc will ____ by about ____.

Accepted Answer

The answer of Assume U.S. and Swiss investors require a...

Question 5

According to the international Fisher effect, if investors in all countries require the same real rate of return, the differential in nominal interest rates between any two countries:

Accepted Answer

According to the international Fisher effect, the differential in nominal interest rates between any two countries is due to their inflation differentials.

Question 6

According to the international Fisher effect, if Venezuela has a much higher nominal rate than other countries, its inflation rate will likely be ____ than other countries, and its currency will ____.

Accepted Answer

The international Fisher effect suggests that the currency of a country with a higher nominal interest rate will depreciate over time as investors demand a higher return to compensate for the higher inflation rate. Therefore, if Venezuela has a much higher nominal interest rate than other countries, its currency will likely weaken compared to the currencies of other countries, and its inflation rate will likely be higher than other countries.

Question 7

The Fisher effect is used to determine the:

Accepted Answer

The Fisher effect relates to the relationship between nominal interest rate, inflation rate, and real interest rate. It states that real interest rate equals nominal interest rate minus inflation rate. Therefore, the Fisher effect is used to determine the real interest rate.

Question 8

Assume that U.S. and British investors require a real return of 2%. If the nominal U.S. interest rate is 15%, and the nominal British rate is 13%, then according to the IFE, the British inflation rate is expected to be about ____ the U.S. inflation rate, and the British pound is expected to ____.

Accepted Answer

The answer of Assume that U.S. and British investors require...

Question 9

If the international Fisher effect (IFE) did not hold based on historical data, then this suggests that:

Accepted Answer

If the IFE did not hold, it implies that the expected changes in exchange rates do not offset the interest rate differentials between countries. Therefore, corporations could have potentially earned higher returns from foreign short-term investments compared to domestic ones.

Question 10

According to the international Fisher effect, if U.S. investors expect a 5% rate of domestic inflation over one year, and a 2% rate of inflation in European countries that use the euro, and require a 3% real return on investments over one year, the nominal interest rate on one-year U.S. Treasury securities would be:

Accepted Answer

The international Fisher effect states that the difference in nominal interest rates between two countries is equal to the difference in their expected inflation rates.

Using this formula, we can calculate the expected nominal interest rate on one-year U.S. Treasury securities:

Nominal interest rate = Real interest rate + Expected inflation rate

Real interest rate = 3%

Expected inflation rate in the U.S. = 5%

Expected inflation rate in Europe = 2%

Difference in expected inflation rates = 5% - 2% = 3%

Therefore, the expected nominal interest rate on one-year U.S. Treasury securities would be:

Nominal interest rate = 3% + 3% = 6%

However, we need to adjust for the fact that the question asks for the nominal interest rate in dollars, while the expected inflation rates are given in euros. To do this, we need to use the exchange rate between dollars and euros:

1 euro = 1 / 1.02 dollars

So the expected inflation rate in Europe in dollars is:

2% * (1 / 1.02) = 1.96%

Therefore, the actual expected nominal interest rate on one-year U.S. Treasury securities is:

Nominal interest rate = 3% + 1.96% + 5% = 9.96%

Rounding to the nearest whole number gives an answer of 10%, or 8% in choice (E) with the correct adjustment for the exchange rate.

Question 11

Under purchasing power parity, the future spot exchange rate is a function of the initial spot rate in equilibrium and:

Accepted Answer

According to the theory of purchasing power parity, the future spot exchange rate will be dependent on the inflation differential between two countries. The initial spot rate in equilibrium and the forward discount or premium do not play a role in determining the future spot exchange rate under PPP.

Question 12

According to the IFE, if British interest rates exceed U.S. interest rates:

Accepted Answer

According to the IFE, if British interest rates exceed U.S. interest rates, investors will demand higher returns in British investments, causing an increase in demand for British pounds. This increased demand will cause the value of the British pound to appreciate against the dollar. Therefore, the correct answer is B.

Question 13

Latin American countries have historically experienced relatively high inflation, and their currencies have weakened. This information is somewhat consistent with the concept of:

Accepted Answer

The concept of purchasing power parity suggests that in the long run, the exchange rate between two currencies should adjust to reflect the relative price levels between the two countries. If inflation is higher in a country, its currency will weaken relative to other countries with lower inflation. Latin American countries being historically characterized by high inflation and weakened currencies is consistent with this concept.

Question 14

Assume that the U.S. and Chile nominal interest rates are equal. Then, the U.S. nominal interest rate decreases while the Chilean nominal interest rate remains stable. According to the international Fisher effect, this implies expectations of ____ than before, and that the Chilean peso should ____ against the dollar.

Accepted Answer

The answer of Assume that the U.S. and Chile nominal...

Question 15

Given a home country and a foreign country, purchasing power parity suggests that:

Accepted Answer

Purchasing power parity (PPP) suggests that in the long run, exchange rates should adjust so that an identical good in two different countries will have the same price when expressed in a common currency. It does not imply that inflation rates or nominal interest rates of both countries will be the same.

Question 16

Because there are sometimes no substitutes for traded goods, this will:

Accepted Answer

The lack of substitutes for traded goods can lead to differences in pricing across countries, making it more difficult for PPP to hold.

Question 17

Given a home country and a foreign country, the international Fisher effect (IFE) suggests that:

Accepted Answer

The International Fisher Effect (IFE) suggests that differences in nominal interest rates between two countries are indicative of expected changes in the exchange rate between those countries' currencies. It does not imply that nominal interest rates or inflation rates are the same across countries, nor does it suggest that exchange rates move in a similar direction against other currencies.

Question 18

Because there are a variety of factors in addition to inflation that affect exchange rates, this will:

Accepted Answer

Even though inflation is one of the factors affecting exchange rates, there are several other factors, such as market sentiment, political developments, and speculation. These factors can cause exchange rate deviations from their PPP values, making it less likely for PPP to hold.

Question 19

If interest rate parity holds, then the one-year forward rate of a currency will be ____ the predicted spot rate of the currency in one year according to the international Fisher effect.

Accepted Answer

According to interest rate parity, the forward exchange rate should be set so that an investor in either currency will earn the same return. This means that the forward rate should equal the predicted spot rate adjusted for differences in interest rates between the two currencies. The international Fisher effect predicts that the currency with the higher interest rate will depreciate by the amount necessary to eliminate the interest rate differential. Therefore, the predicted spot rate in one year should be adjusted downward for the higher interest rate currency. If interest rate parity holds, the forward rate should be equal to this adjusted predicted spot rate, so the answer is C, equal to.

Question 20

Given a home country and a foreign country, purchasing power parity (PPP) suggests that:

Accepted Answer

Purchasing power parity (PPP) suggests that a currency will depreciate if the home country's inflation rate is higher than the foreign country's inflation rate, as higher inflation reduces the currency's purchasing power.

Quiz 8: Relationships Among Inflation, Interest Rates, and Exchange Rates