Question 1

The price of gold is $300 per ounce in New York and 435 Canadian dollars per ounce in Toronto, Canada. If the law of one price holds for gold, the nominal exchange rate is ________ Canadian dollars per U.S. dollar.

Accepted Answer

If the law of one price holds, which we expect, then 435 Canadian dollars/ 300 U.S. dollars = 1.45 Canadian dollars per U.S. dollar should be the relative value of the two currencies.

Question 2

U.S. households wishing to purchase shares of stock in a European company are ________ the foreign exchange market.

Accepted Answer

When U.S. households wish to purchase shares of stock in a foreign company, the households need to obtain foreign currency first. To do this, the household supplies dollars in exchange for foreign currency.

Question 3

According to the theory of purchasing power parity, the real exchange rate between two currencies will equal ________ in the long run.

Accepted Answer

The law of one price says that goods will fetch the same price worldwide so long as transportation costs are low, this means the real exchange rate will be equal to 1.

Question 4

The PPP theory is most useful in predicting:

Accepted Answer

The PPP theory predicts better in the long run than the short run. Also, the theory predicts better for tradable, standardized goods than for other goods and services.

Question 5

If a certain automotive part can be purchased in Mexico for 60 pesos or in the United States for $6.25 and if the nominal exchange rate is 8 pesos per U.S. dollar, then the automotive part:

Accepted Answer

The part is less expensive in the United States. This is because one dollar buys 8 pesos and 6.25 dollars buys 50 pesos, and the automotive part required 62 pesos in Mexico.

Question 6

Purchasing power parity is the theory that nominal exchange rates are determined:

Accepted Answer

Since the law of one price says that a given good will fetch the same price worldwide, then nominal exchange rates are determined to uphold the law of one price. This theory of nominal exchange rates is called purchasing power parity.

Question 7

European households wishing to purchase shares of stock in an American company are ________ the foreign exchange market.

Accepted Answer

When European households wish to purchase U.S. shares of stock, the European households need first to obtain dollars. To do this, the households demand U.S. dollars in the foreign exchange market.

Question 8

European firms wishing to purchase American goods and services are ________ the foreign exchange market.

Accepted Answer

When European firms wish to purchase U.S. goods and services, the European firm needs first to obtain dollars. To do this, the firms demand U.S. dollars in the foreign exchange market.

Question 9

The theory that nominal exchange rates are determined so that the law of one price holds is called:

Accepted Answer

Since the law of one price says that a given good will fetch the same price worldwide, then nominal exchange rates are determined to uphold the law of one price. This relationship is called purchasing power parity.

Question 10

The purchasing power parity theory is not a good explanation of how nominal exchange rates are determined in the short run because:

Accepted Answer

The purchasing power parity theory relies on two conditions in the short run: the goods and services must be tradable and standardized.

Question 11

U.S. firms wishing to purchase European goods and services are ________ the foreign exchange market.

Accepted Answer

U.S. firms buy billions of dollars' worth of European goods and services every year. They pay for these purchases by supplying U.S. dollars to the foreign exchange market.

Question 12

There is ________ connection between the strength of a country's currency and the strength of its ________.

Accepted Answer

Because exchange rates are affected by many forces both domestic and foreign, there is no simple connection between the strength of a country's currency and the strength of its economy.

Question 13

Based on the theory of purchasing power parity, in the long run, currencies of countries with significant inflation will tend to:

Accepted Answer

Based on the purchasing power parity theory, in the long run countries with significant inflation will see their currencies depreciate because the nominal exchange rate will be equal to the reciprocal of the ratio of the price levels.

Question 14

Suppose the price of gold is $300 per ounce in the United States and 2,400 pesos per ounce in Mexico. If purchasing power parity holds and if the price of oil is 200 pesos per barrel in Mexico, the price of oil is ________ per barrel in the United States.

Accepted Answer

If purchasing power parity holds, then the relative value of the dollar and peso will be the same when buying a tradable commodity like oil or gold. Thus, since 2,400 pesos/ $300 = 8 pesos per dollar, the price of oil in the U.S. must be 200/8 = 25 dollars per barrel.

Question 15

Suppose the price of gold is $300 per ounce in the United States and 2,400 pesos per ounce in Mexico. If purchasing power parity holds and if the price of oil is $25 per barrel in the United States, the price of oil is ________ pesos per barrel in Mexico.

Accepted Answer

If purchasing power parity holds, then the relative value of the dollar and peso will be the same when buying a tradable commodity like oil or gold. Thus, since 2,400 pesos/ $300 = 8 pesos per dollar, the price of oil in Mexico must be 8 × 25 = 200 pesos per barrel.

Question 16

The purchasing power parity theory is a reasonably good explanation for nominal exchange rate determination:

Accepted Answer

Empirical studies have found that the PPP theory is useful for predicting changes in nominal exchange rates over the relatively long run. In particular, this theory helps to explain the tendency of countries with high inflation to experience depreciation of their exchange rates.

Question 17

Suppose the price of gold is initially $300 per ounce in New York and 450 Canadian dollars per ounce in Toronto, Canada. If the law of one price holds for gold, the nominal exchange rate is ________ Canadian dollars per U.S. dollar. If Canada experiences inflation, such that the price of gold rises to 510 Canadian dollars per ounce, but the U.S. does not experience any inflation, the nominal exchange rate would be ________ Canadian dollars per U.S. dollar.

Accepted Answer

If the law of one price holds, the nominal exchange rate is 450/300 = 1.50 Canadian dollars per U.S. dollar. If Canada experiences inflation but the U.S. does not, then the nominal exchange rate is 510/ 300 = 1.70 Canadian dollars per U.S. dollar.

Question 18

The principal demanders of U.S. dollars in the foreign exchange market are:

Accepted Answer

U.S. households and firms buy billions of dollars' worth of foreign goods and services every year. They pay for these purchases by supplying U.S. dollars to the foreign exchange market.

Question 19

The price of gold is $300 per ounce in New York and 2,550 pesos per ounce in Mexico City. If the law of one price holds for gold, the nominal exchange rate is ________ pesos per U.S. dollar.

Accepted Answer

If the law of one price holds, which we expect, then 2,550 pesos/ 300 dollars = 8.5 pesos per dollar should be the relative value of the two currencies.

Question 20

The law of one price states that if transportation costs are relatively small, then the:

Accepted Answer

The law of one price says that goods will fetch the same price worldwide so long as transportation costs are low.

Quiz 28: Exchange Rates and the Open Economy