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

Question 1

According to purchasing power parity (PPP), if a foreign country's inflation rate is below the inflation rate at home, home country consumers will increase their imports from the foreign country, and foreign consumers will lower their demand for home country products. These market forces cause the foreign currency to appreciate.

Answer 1

True

Question 2

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.

Answer 2

True

Question 3

According to the IFE, when the nominal interest rate at home exceeds the nominal interest rate in the foreign country, the home currency should depreciate.

Answer 3

True

Question 4

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

Question 5

Brazil has a very high interest rate. According to _____, the Brazilian real should depreciate substantially.

A) purchasing power parity (PPP)
B) the international Fisher effect (IFE)
C) interest rate parity (IRP)
D) purchasing power parity (PPP) AND the international Fisher effect (IFE)

Question 6

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 7

​The inflation rate in the United States is 3 percent while the inflation rate in Japan is 10 percent. The current exchange rate for the Japanese yen (¥) is $0.0075. After supply and demand for the Japanese yen have adjusted in the manner suggested by purchasing power parity, the new exchange rate for the yen will be:

A) ​$0.0076.
B) ​$0.0073.
C) ​$0.0070.
D) ​$0.0066.

Question 8

There is much evidence to suggest that Japanese investors invest in U.S. Treasury securities when U.S. interest rates are higher than Japanese interest rates. These investors most likely believe in the international Fisher effect.

Question 9

If purchasing power parity holds, then the Fisher effect must also hold.

Question 10

Purchasing power parity (PPP) focuses on the relationship between nominal interest rates and exchange rates between two countries.

Question 11

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

Question 12

The nominal interest rate can be measured as the real interest rate minus the expected inflation rate.

Question 13

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

Question 14

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

Question 15

The international Fisher effect (IFE) suggests that the currencies with relatively high interest rates will appreciate because those high rates will attract investment and increase the demand for that currency.

Question 16

If the IFE theory holds, that means that covered interest arbitrage is not feasible.

Question 17

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 18

Assume that inflation in the United States is expected to be 9 percent, while inflation in Australia is expected to be 5 percent over the next year. Today you receive an offer to purchase a one-year put option for $.03 per unit on Australian dollars at a strike price of $0.72. Today the Australian dollar is quoted at $0.70. You believe that purchasing power parity holds. You should accept the offer.

Question 19

If the international Fisher effect (IFE) holds, the local investors are expected to earn the same return from investing internationally as they would from investing in their local markets.

Question 20

​Assume that the international Fisher effect (IFE) holds between the United States and the United Kingdom. The U.S. inflation is expected to be 5 percent, while British inflation is expected to be 3 percent. The interest rate offered on pounds is 7 percent, and the U.S. interest rate is 7 percent. What does this say about real interest rates expected by British investors?

A) ​Real interest rates expected by British investors are equal to the interest rates expected by U.S. investors.
B) ​Real interest rates expected by British investors are 2 percentage points lower than the real interest rates expected by U.S. investors.
C) ​Real interest rates expected by British investors are 2 percentage points above the real interest rates expected by U.S. investors.
D) ​IFE doesn't hold in this case because the U.S. inflation is higher than the British inflation, but the interest rates offered in both countries are equal.

Question 21

Which of the following is not true regarding limitations of PPP and the IFE?

A) A limitation of the IFE is that the determination of the expected inflation rate is subject to error.
B) A limitation in testing PPP is that the results will vary with the base period used.
C) A limitation of the PPP and the IFE (because it relies on the PPP) is that other country characteristics besides inflation can affect exchange rate movements.
D) All of these are true.

Question 22

Which of the following theories can be assessed using data that exists at one specific point in time?

A) purchasing power parity (PPP)
B) international Fisher effect (IFE)
C) purchasing power parity (PPP) AND international Fisher effect (IFE)
D) interest rate parity (IRP)

Question 23

Among the reasons that purchasing power parity (PPP) does not consistently occur are:

A) exchange rates are affected by interest rate differentials.
B) exchange rates are affected by national income differentials and government controls.
C) supply and demand may not adjust if no substitutable goods are available.
D) All of these are reasons that PPP does not consistently occur.

Question 24

​The international Fisher effect (IFE) suggests that the foreign currency will appreciate when:

A) ​the current home nominal interest rate exceeds the current foreign nominal interest rate.
B) ​the current home real interest rate exceeds the current foreign real interest rate.
C) ​the current home inflation rate exceeds the current foreign nominal interest rate.
D) ​the current foreign inflation rate exceeds the current home inflation rate.

Question 25

The inflation rate in the United States is 4 percent, while the inflation rate in Japan is 1.5 percent. The current exchange rate for the Japanese yen (¥) is $0.0080. After supply and demand for the Japanese yen have adjusted according to purchasing power parity, the new exchange rate for the yen will be:

A) $0.0078.
B) $0.0082.
C) $0.0111.
D) $0.00492.
E) None of these are correct.

Question 26

If interest rates on the euro are consistently below U.S. 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 27

​According to the international Fisher effect (IFE):

A) ​the nominal rate of return on a foreign investment should be equal to the nominal rate of return on the domestic investment.
B) ​the exchange rate-adjusted rate of return on a foreign investment should be equal to the interest rate on a local money market investment.
C) ​the percentage change in the foreign spot exchange rate will be positive if the foreign interest rate is higher than the local interest rate.
D) ​the percentage change in the foreign spot exchange rate will be negative if the foreign interest rate is lower than the local interest rate.

Question 28

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

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

Question 29

​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 30

​Which of the following theories suggests that the percentage difference between the forward rate and the spot rate depends on the interest rate differential between two countries?

A) ​purchasing power parity (PPP)
B) ​triangular arbitrage
C) ​international Fisher effect (IFE)
D) ​interest rate parity (IRP)

Question 31

Which of the following is not true regarding IRP, PPP, and the IFE?

A) IRP suggests that a currency's spot rate will change according to interest rate differentials.
B) PPP suggests that a currency's spot rate will change according to inflation differentials.
C) The IFE suggests that a currency's spot rate will change according to interest rate differentials.
D) All of these are true.

Question 32

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 these are correct.

Question 33

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.

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

Question 34

​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 less pronounced 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 35

​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 36

​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.

A) ​lower U.S. inflation; depreciate
B) ​lower U.S. inflation; appreciate
C) ​higher U.S. inflation; depreciate
D) ​higher U.S. inflation; appreciate

Question 37

Assume that U.S. and British investors require a real return of 2 percent. If the nominal U.S. interest rate is 15 percent, and the nominal British rate is 13 percent, 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 ____.

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

Question 38

​Assume that the U.S. inflation rate is higher than the New Zealand inflation rate. This will cause U.S. consumers to ____ their imports from New Zealand and New Zealand consumers to ____ their imports from the United States. According to purchasing power parity (PPP), this will result 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 39

​According to the IFE, if British interest rates exceed U.S. 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 40

​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 41

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 these are correct.

Question 42

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

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

Question 43

If the international Fisher effect (IFE) did not hold based on historical data, this would suggest that:​

A) ​some corporations with excess cash could 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 44

The following regression was conducted for the exchange rate of the British pound (BP): 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 45

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

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

Question 46

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) is zero AND is constant over time.

Question 47

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) the inflation rates of both countries will be the same AND the nominal interest rates of both countries will be the same.
D) None of these are correct.

Question 48

Which of the following is true regarding the IFE?

A) Results from testing the IFE will vary depending on the specific time frame and currency that are tested.
B) The IFE relies on the PPP relationship between inflation and exchange rates, which is subject to error.
C) In general, exchange rate movements of most currencies frequently exhibit substantial deviations from what the IFE would predict.
D) All of these are true.
Answer Key

Question 49

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

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

Question 50

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

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

Question 51

​Assume that the one-year interest rate in the United States is 7 percent and in the United Kingdom is 5 percent. According to the international Fisher effect, the British pound's spot exchange rate should ____ by about ____ over the year.

A) ​depreciate; 1.9 percent
B) ​appreciate; 1.9 percent
C) ​depreciate; 3.94 percent
D) ​appreciate; 3.94 percent

Question 52

Assume that the interest rate offered on pounds is 5 percent and the pound is expected to depreciate by 1.5 percent. For the international Fisher effect (IFE) to hold between the United Kingdom and the United States, the U.S. interest rate should be:

A) 3.43 percent.
B) 5.68 percent.
C) 6.5 percent.
D) 7.3 percent.

Question 53

​The following regression analysis was conducted for the inflation rate information and exchange rate of the British pound: Regression results indicate that a₀ = 0 and a₁ = 1. 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 54

​According to the international Fisher effect, if Venezuela has a much higher nominal interest 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 55

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

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

Question 56

Which of the following theories suggests the percentage change in the spot exchange rate of a currency should be equal to the interest rate differential between two countries?

A) absolute form of PPP
B) relative form of PPP
C) international Fisher effect (IFE)
D) interest rate parity (IRP)

Question 57

​Assume that the U.S. one-year interest rate is 5 percent and the one-year interest rate on euros is 8 percent. You have $100,000 to invest and you believe that the international Fisher effect (IFE) holds. The euro's spot exchange rate is $1.40. What will be the yield on your investment if you invest in euros?

A) ​8 percent
B) ​5 percent
C) ​3 percent
D) ​2.78 percent

Question 58

If nominal British interest rates are 3 percent and nominal U.S. interest rates are 6 percent, then the British pound (£) is expected to ____ by about ____percent, 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 these are correct.

Question 59

​Which of the following theories suggests that the percentage change in the spot exchange rate of a currency should be equal to the inflation differential between two countries?

A) ​purchasing power parity (PPP)
B) ​triangular arbitrage
C) ​international Fisher effect (IFE)
D) ​interest rate parity (IRP)