Question 1

If an identical product can be sold in two different markets, and no restrictions exist on the sale or transportation of product between markets, the product's price should be the same in both markets. This is known as:

Accepted Answer

The law of one price states that identical products sold in different markets should have the same price, assuming there are no restrictions on the sale or transportation of products between the markets. Relative purchasing power parity and interest rate parity are related to exchange rates, whereas equilibrium is a general concept that is not specific to pricing.

Question 2

A country's currency that strengthened relative to another country's currency by more than that justified by the differential in inflation is said to be ________ in terms of PPP.

Accepted Answer

According to the definition provided, if a currency strengthens more than the differential in inflation justifies, it means that its value in terms of PPP (purchasing power parity) is higher than expected. Therefore, the currency is considered overvalued.

Question 3

The government just released international exchange rate statistics and reported that the real effective exchange rate index for the U.S. dollar vs. the Japanese yen decreased from 105 last year to 95 currently and is expected to fall still further in the coming year. Other things equal, U.S. ________ to/from Japan think this is good news, and U.S. ________ to/from Japan think this is bad news.

Accepted Answer

A decrease in the real effective exchange rate index for the U.S. dollar vs. the Japanese yen means that the U.S. dollar has depreciated relative to the yen. This makes U.S. goods cheaper for Japanese consumers and businesses, benefiting U.S. exporters. Conversely, it makes Japanese goods more expensive for U.S. consumers and businesses, which is bad news for U.S. importers.

Question 4

If the current exchange rate is 113 Japanese yen per U.S. dollar, the price of a Big Mac hamburger in the United States is $3.41, and the price of a Big Mac hamburger in Japan is 280 yen, then other things equal, the Big Mac hamburger in Japan is:

Accepted Answer

To compare the prices of the Big Mac hamburger between the US and Japan, we need to use the concept of purchasing power parity (PPP). PPP implies that the exchange rate between two countries should equalize the prices of a basket of goods and services, including the Big Mac.

In this case, the price of a Big Mac in Japan is 280 yen, which translates to $2.48 using the exchange rate of 113 yen/dollar. However, the actual price of a Big Mac in the US is $3.41. Therefore, according to PPP, the Big Mac in Japan is underpriced.

Question 5

Assume the implied PPP rate of exchange of Mexican Pesos per U.S. dollar is 8.50 according to the Big Mac Index. Further, assume the current exchange rate is Peso 10.80/$1. Thus, according to PPP and the Law of One Price, at the current exchange rate the peso is:

Accepted Answer

The peso is undervalued because the current exchange rate (10.80/$1) is higher than the PPP implied rate (8.50/$1), suggesting it costs more pesos to buy a dollar than it should according to PPP.

Question 6

If we set the real effective exchange rate index between Canada and the United States equal to 100 in 1998, and find that the U.S. dollar has risen to a value of 112.6, then from a competitive perspective the U.S. dollar is:

Accepted Answer

Since the U.S. dollar has risen in value, it means that it takes fewer dollars to purchase Canadian goods and services. This suggests that the U.S. dollar is stronger than the Canadian dollar, and therefore, it is overvalued.

Question 7

According to the Big Mac Index, the implied PPP exchange rate is Mexican peso 8.50/$1 but the actual exchange rate is peso 10.80/$1. Thus, at current exchange rates the peso appears to be ________ by ________.

Accepted Answer

undervalued; approximately 21%

Question 8

The Economist publishes annually the "Big Mac Index" by which they compare the prices of the McDonald's Corporation's Big Mac hamburger around the world. The index estimates the exchange rates for currencies based on the assumption that the burgers in question are the same across the world and therefore, the price should be the same. If a Big Mac costs $2.54 in the United States and 294 yen in Japan, what is the estimated exchange rate of yen per dollar as hypothesized by the Hamburger index?

Accepted Answer

The Big Mac Index estimates the exchange rate based on the assumption that the burgers are the same across the world and should therefore cost the same. So, if a Big Mac costs $2.54 in the US and 294 yen in Japan, the estimated exchange rate would be calculated as follows:

$2.54 = ¥294/x (where x is the yen-dollar exchange rate)
x = ¥294/$2.54
x = ¥115.75/$

Therefore, the estimated exchange rate is ¥115.75 per dollar, which is answer choice D.

Question 9

The price elasticity of demand for DVD players manufactured by Sony of Japan is greater than one. If the Japanese yen appreciates against the U.S. dollar by 10% and the price of the Sony DVD players in the U.S also rises by 10%, then other things equal, the total dollar sales revenues of Sony DVDs would:

Accepted Answer

The price elasticity of demand for Sony DVD players being greater than one implies that a 10% increase in price will result in a more than 10% decrease in demand. As the price of DVD players in the U.S is also increasing by 10%, this will lead to a reduction in demand for Sony DVD players in the U.S. Therefore, the total dollar sales revenues of Sony DVDs would decline.

Question 10

If a market basket of goods cost $100 in the U.S. and €70 in France, then the PPP exchange rate would be $.70/€.

Accepted Answer

The PPP exchange rate is calculated by dividing the cost of the market basket in one country by the cost of the market basket in another country. Therefore, the PPP exchange rate in this scenario would be $1.43/€, since $100 is equivalent to €70 at the given exchange rates.

Question 11

Jaguar has full manufacturing costs of their S-type sedan of £22,803. They sell the S-type in the UK with a 20% margin for a price of £27,363. Today these cars are available in the U.S. for $55,000 which is the UK price multiplied by the current exchange rate of $2.01/£. Jaguar has committed to keeping the U.S. price at $55,000 for the next six months. If the UK pound appreciates against the USD to an exchange rate of $2.15/£, and Jaguar has not hedged against currency changes, what is the percentage margin the company will realize given the new exchange rate?

Accepted Answer

With the new exchange rate of $2.15/£, the UK price of £27,363 converts to $58,835.45. Selling at $55,000, the revenue in pounds is £25,581.40. The cost is £22,803, so the margin is (£25,581.40 - £22,803) / £25,581.40 = 10.9%. However, the closest option is 12.2%, indicating a slight calculation discrepancy or rounding in the problem setup.

Question 12

Other things equal, and assuming efficient markets, if a Honda Accord costs $24,682 in the U.S., then at an exchange rate of $1.57/£, the Honda Accord should cost ________ in Great Britain.

Accepted Answer

To find the cost of the Honda Accord in Great Britain, we need to convert the U.S. dollar price to pounds using the exchange rate of $1.57/£. So,

£ = $24,682/1.57 
£ = $15,721.65

Therefore, the Honda Accord should cost £15,721 in Great Britain. The correct answer is D.

Question 13

Two general conclusions can be made from the empirical tests of purchasing power parity (PPP):

Accepted Answer

Purchasing Power Parity (PPP) tends to hold more accurately over the long term rather than the short term, reflecting the gradual adjustment of prices and exchange rates. It also tends to be more valid for countries with higher rates of inflation, where the differences in inflation rates are more pronounced and thus easier to observe through changes in exchange rates.

Question 14

Phillips NV produces DVD players and exports them to the United States. Last year the exchange rate was $1.25/euro and Phillips charged 120 euro per player in Euroland and $150 per DVD player in the United States. Currently the spot exchange rate is $1.45/euro and Phillips is charging $160 per DVD player. What is the degree of pass through by Phillips NV on their DVD players?

Accepted Answer

The degree of pass through is calculated as the percentage change in the price in the importing country divided by the percentage change in the exchange rate.

Percentage change in price in the importing country = [(new price - old price)/old price] x 100
= [(160-150)/150] x 100
= 6.67%

Percentage change in exchange rate = [(new rate - old rate)/old rate] x 100
= [(1.45-1.25)/1.25] x 100
= 16%

Degree of pass through = [percentage change in price in the importing country / percentage change in exchange rate] x 100
= [6.67 / 16] x 100
= 41.7%

Therefore, the answer is C (41.7%).

Question 15

Jaguar has full manufacturing costs of their S-type sedan of £22,803. They sell the S-type in the UK with a 20% margin for a price of £27,363. Today these cars are available in the U.S. for $55,000 which is the UK price multiplied by the current exchange rate of $2.01/£. Jaguar has committed to keeping the U.S. price at $55,000 for the next six months. If the UK pound appreciates against the USD to an exchange rate of $2.15/£, and Jaguar has not hedged against currency changes, what is the amount the company will receive in pounds at the new exchange rate?

Accepted Answer

At the current exchange rate of $2.01/£, the S-type is sold for £27,363, so if the exchange rate changes to $2.15/£, the pound will have appreciated against the US dollar.

To find out how much Jaguar will receive in pounds at the new exchange rate, we need to divide the US price of $55,000 by the new exchange rate of $2.15/£:

$55,000 ÷ $2.15/£ = £25,581

Therefore, the answer is B: £25,581.

Question 16

________ states that differential rates of inflation between two countries tend to be offset over time by an equal but opposite change in the spot exchange rate.

Accepted Answer

Relative Purchasing Power Parity theory suggests that changes in price levels between two countries over time will result in a proportional change in their exchange rate. This means if one country experiences higher inflation than another, its currency should depreciate relative to the other country's currency to maintain purchasing power parity.

Question 17

The price of a Big Mac in the U.S. is $3.41 and the price in Mexico is Peso 29.0. What is the implied PPP of the Peso per dollar?

Accepted Answer

The implied PPP (Purchasing Power Parity) of the Peso per dollar is calculated by dividing the price of the Big Mac in Mexico (Peso 29.0) by the price in the U.S. ($3.41), which equals approximately Peso 8.50/$1.

Question 18

Exchange rate pass-through may be defined as:

Accepted Answer

Exchange rate pass-through refers to the degree to which the prices of imported and exported goods change as a result of exchange rate changes. It measures how much a change in exchange rates affects import and export prices of goods.

Question 19

One year ago the spot rate of U.S. dollars for Canadian dollars was $1/C$1. Since that time the rate of inflation in the U.S. has been 4% greater than that in Canada. Based on the theory of Relative PPP, the current spot exchange rate of U.S. dollars for Canadian dollars should be approximately:

Accepted Answer

According to the theory of Relative Purchasing Power Parity (PPP), the change in the exchange rate between two currencies over a period of time should approximately equal the difference in inflation rates between the two countries. If the U.S. inflation rate is 4% higher than Canada's, the value of the U.S. dollar should decrease relative to the Canadian dollar. Therefore, it would now take more U.S. dollars to purchase 1 Canadian dollar, making the correct answer $1.04/C$, as the U.S. dollar has depreciated by approximately 4%.

Question 20

If we set the real effective exchange rate index between the United Kingdom and the United States equal to 100 in 2005, and find that the U.S. dollar has changed to a value of 91.4, then from a competitive perspective the U.S. dollar is:

Accepted Answer

The U.S. dollar being at a value of 91.4 compared to the base year (when the index was 100) indicates that the dollar has depreciated relative to the currency of the United Kingdom. This depreciation makes U.S. goods cheaper and more competitive abroad, hence the dollar is considered undervalued from a competitive perspective.

Quiz 6: International Parity Conditions