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

Question 1

Interest rate parity can only hold if purchasing power parity holds.

Answer 1

False

Question 2

Assume that the inflation rate in Barbados is 3.20%, while the inflation rate in the UK is 3.00%. According to PPP, the Barbados dollar (BBD) should ____ by ____%.

A) appreciate; 0.1938%
B) depreciate; 0.1938%
C) appreciate; 0.1942%
D) depreciate; 0.1942%

Answer 2

B

Question 3

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:

A) follows their exchange rate movement.
B) is due to their inflation differentials.
C) is zero.
D) is constant over time.
E) C and D

Answer 3

B

Question 4

Assume that the UK inflation rate is higher than the New Zealand inflation rate. This will cause UK consumers to ____ their imports from New Zealand and New Zealand consumers to ____ their imports from the UK. According to purchasing power parity (PPP), this will results in a(n) ____ of the New Zealand dollar (NZ$).

A) reduce; increase; appreciation
B) increase; reduce; appreciation
C) reduce; increase; depreciation
D) reduce; increase; appreciation

Question 5

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

A) reduce the probability that PPP shall hold.
B) increase the probability that PPP shall hold.
C) increase the probability the IFE will hold.
D) B and C

Question 6

Assume that US and British investors require a real return of 2%. If the nominal US 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 US inflation rate, and the British pound is expected to ____.

A) 2 percentage points above; depreciate by about 2%
B) 3 percentage points above; depreciate by about 3%
C) 3 percentage points below; appreciate by about 3%
D) 3 percentage points below; depreciate by about 3%
E) 2 percentage points below; appreciate by about 2%

Question 7

Nominal interest rates in India are 7%, while nominal interest rates in the UK are 5%. The spot rate for the Indian rupee (INR) is £0.120. According to the international Fisher effect (IFE), the rupee should adjust to a new level (to the nearest £0.001) of:

A) £0.015.
B) £0.118.
C) £0.119.
D) £0.121.

Question 8

According to the international Fisher effect (IFE), the exchange rate percentage change should be approximately equal to the differential in income levels between two countries.

Question 9

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

A) greater than
B) less than
C) equal to
D) answer is dependent on whether the forward rate has a discount or premium

Question 10

According to the IFE, if British interest rates exceed US interest rates:

A) the British pound's value will remain constant.
B) the British pound will depreciate against the dollar.
C) the British inflation rate will decrease.
D) the forward rate of the British pound will contain a premium.
E) today's forward rate of the British pound will equal today's spot rate.

Question 11

Research indicates that deviations from purchasing power parity (PPP) are reduced over the long run.

Question 12

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

A) the income differential.
B) the forward discount or premium.
C) the inflation differential.
D) none of the above

Question 13

The relative form of purchasing power parity (PPP) accounts for the possibility of market imperfections such as transportation costs, tariffs, and quotas in establishing a relationship between inflation rates and exchange rate changes.

Question 14

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

A) a home currency will depreciate if the current home inflation rate exceeds the current foreign interest rate.
B) a home currency will appreciate if the current home interest rate exceeds the current foreign interest rate.
C) a home currency will appreciate if the current home inflation rate exceeds the current foreign inflation rate.
D) a home currency will depreciate if the current home inflation rate exceeds the current foreign inflation rate.

Question 15

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

A) some corporations with excess cash can lock in a guaranteed higher return on future foreign short-term investments.
B) some corporations with excess cash could have generated profits on average from covered interest arbitrage.
C) some corporations with excess cash could have generated higher profits on average from foreign short-term investments than from domestic short-term investments.
D) most corporations that consistently invest in foreign short-term investments would have generated the same profits (on average) as from domestic short-term investments.

Question 16

The inflation rate in the euro area is 3%, while the inflation rate in Japan is 1.3%. The current exchange rate for the Japanese yen (¥) is 0.007 euros. After supply and demand for the Japanese yen has adjusted in the manner suggested by purchasing power parity, the new nearest exchange rate for the yen will be:

A) 0.0071 euro.
B) 0.0075 euro.
C) 0.0074 euro.
D) 0.0131 euro.
E) none of the above.

Question 17

Assume that the euro and Chile nominal interest rates are equal. Then, the euro 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 euro.

A) lower euro inflation; depreciate
B) lower euro inflation; appreciate
C) higher euro inflation; depreciate
D) higher euro inflation; appreciate

Question 18

If interest rate parity holds, and the international Fisher effect (IFE) holds, foreign currencies with relatively high interest rates should have forward discounts and those currencies would be expected to depreciate.

Question 19

Which of the following is indicated by research regarding purchasing power parity (PPP)?

A) PPP clearly holds in the short run.
B) Deviations from PPP are reduced in the long run.
C) PPP clearly holds in the long run.
D) There is no relationship between inflation differentials and exchange rate movements in the short run or long run.

Question 20

The IFE theory suggests that foreign currencies with relatively high interest rates will appreciate because the high nominal interest rates reflect expected inflation.

Question 21

The interest rate parity theory offers a direct explanation regarding why exchange rates change over time.

Question 22

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

A) the value of the euro would often appreciate against the dollar.
B) the value of the euro would often depreciate against the dollar.
C) the value of the euro would remain constant most of the time.
D) the value of the euro would appreciate in some periods and depreciate in other periods, but on average have a zero rate of appreciation.

Question 23

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

A) interest rate parity.
B) locational arbitrage.
C) purchasing power parity.
D) the exchange rate mechanism.

Question 24

If interest rate parity holds, then the international Fisher effect must hold.

Question 25

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

A) reduce the probability that PPP shall hold.
B) increase the probability that PPP shall hold.
C) increase the probability the IFE will hold.
D) B and C

Question 26

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

A) appreciate; 3%
B) appreciate; 1%
C) depreciate; 3%
D) depreciate; 2%
E) appreciate; 2%

Question 27

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

A) the inflation rates of both countries will be the same.
B) the nominal interest rates of both countries will be the same.
C) A and B
D) none of the above.

Question 28

The international Fisher effect (IFE) suggests that:

A) a home currency will depreciate if the current home interest rate exceeds the current foreign interest rate.
B) a home currency will appreciate if the current home interest rate exceeds the current foreign interest rate.
C) a home currency will appreciate if the current home inflation rate exceeds the current foreign inflation rate.
D) a home currency will depreciate if the current home inflation rate exceeds the current foreign inflation rate.

Question 29

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 ____.

A) lower; strengthen
B) lower; weaken
C) higher; weaken
D) higher; strengthen

Question 30

If nominal British interest rates are 3% and nominal US interest rates are 6%, then the British pound (£) is expected to ____ by about ____%, according to the international Fisher effect (IFE).

A) depreciate; 2.9
B) appreciate; 2.9
C) depreciate; 1.0
D) appreciate; 1.0
E) none of the above

Question 31

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?

A) If Country A's inflation rate exceeds Country B's inflation rate, Country A's currency will weaken.
B) If Country A's interest rate exceeds Country B's inflation rate, Country A's currency will weaken.
C) If Country A's interest rate exceeds Country B's inflation rate, Country A's currency will strengthen.
D) If Country B's inflation rate exceeds Country A's inflation rate, Country A's currency will weaken.

Question 32

The Fisher effect is used to determine the:

A) real inflation rate.
B) real interest rate.
C) real spot rate.
D) real forward rate.

Question 33

The following regression analysis was conducted for the inflation rate information and exchange rate of the US dollar: ​
E_BP = a₀ + a₁ * [(1 + I _US)/(1 + I_B) -1] + μ
​
Regression results indicate that a₀ = 0 and a₁ = 2. Therefore:

A) purchasing power parity holds.
B) purchasing power parity overestimated the exchange rate change during the period under examination.
C) purchasing power parity underestimated the exchange rate change during the period under examination.
D) purchasing power parity will overestimate the exchange rate change of the British pound in the future.

Question 34

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

A) 2%.
B) 3%.
C) -2%.
D) 5%.
E) 8%.

Question 35

You have an opportunity to invest in Australia at an interest rate of 8%. Moreover, you expect the Australian dollar (A$) to appreciate by 2%. Your effective return from this investment is:

A) 8.00%.
B) 6.00%.
C) 10.16%.
D) 5.88%.

Question 36

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

A) the nominal interest rates of both countries are the same.
B) the inflation rates of both countries are the same.
C) the exchange rates of both countries will move in a similar direction against other currencies.
D) none of the above.