Question 1

Which one of the following parity theories states that,in its absolute version,price levels globally should be equal when expressed in a common currency?

Accepted Answer

Purchasing power parity theory states that the exchange rate between two countries is in equilibrium when their domestic purchasing powers at that rate of exchange are equivalent. In its absolute version, this theory states that the price levels in different countries should be equal when expressed in a common currency.

Question 2

On January 1,1990,the annual inflation rates in the U.S.and Greece were expected to be 3% and 8%,respectively.If the current spot rate that day for the drachma was $.007,then the expected spot rate in three years was

Accepted Answer

The expected spot rate can be calculated using the formula for purchasing power parity: Expected Spot Rate = Current Spot Rate * (1 + Inflation Rate of Domestic Country) / (1 + Inflation Rate of Foreign Country). Applying this: $.007 * (1 + 0.03)^3 / (1 + 0.08)^3 = $.00607.

Question 3

If the expected inflation rate is 5% and the real required return is 6%,then the Fisher effect says that the nominal interest rate should be

Accepted Answer

According to the Fisher effect, the nominal interest rate can be calculated as:
nominal rate = real rate + expected inflation
= 6% + 5%
= 11%
Therefore, the correct option is (B) 11.3%.

Question 4

On January 1,1994,the annual inflation rates in the U.S.and Italy were expected to be 4% and 7%,respectively.If the current spot rate on that day was $1 = L2,000,then the expected spot rate for the lira in three years was

Accepted Answer

The correct answer is A because the expected spot rate for the lira in three years is $1 = L2,000 * (1 + 0.07)^3 / (1 + 0.04)^3 = $1 = L2,000 * 1.216 / 1.125 = $1 = L2,160. Therefore, the expected spot rate for the lira in three years is $1 = L2,160, which is equal to $0.0004591.

Question 5

If expected inflation is 20% and the real required return is 10%,then the Fisher effect says that the nominal interest rate should be exactly

Accepted Answer

The Fisher effect formula is (1 + nominal rate) = (1 + real rate) * (1 + inflation rate). Plugging in the given values: (1 + nominal rate) = (1 + 0.10) * (1 + 0.20) = 1.10 * 1.20 = 1.32. Therefore, the nominal rate = 32%.

Question 6

When a rise in the expected inflation rate in one nation relative to others will be associated with an expected fall in the first nation's exchange rate accompanied by a rise of its expected interest rate relative to foreign expected interest rates,we are describing the

Accepted Answer

The International Fisher Effect states that a higher expected inflation rate in one country relative to others will lead to a decrease in its exchange rate and an increase in its interest rate relative to foreign interest rates. This is because investors will demand a higher return on their investments to compensate for the expected loss in purchasing power due to inflation.

Question 7

The inflation rates in the U.S.and France in January 1991 were expected to be 4% per annum and 7% per annum,respectively.If the current spot rate that day was $.1050,then the expected spot rate in three years was

Accepted Answer

The expected spot rate can be calculated using the formula for purchasing power parity: Expected Spot Rate = Current Spot Rate * (1 + Inflation Rate of Domestic Country) / (1 + Inflation Rate of Foreign Country). Plugging in the values: $.1050 * (1 + 0.04)^3 / (1 + 0.07)^3 = $.0964.

Question 8

The Fisher effect states that the _________ rate is made up of a real required rate of return and an inflation premium.

Accepted Answer

The Fisher effect asserts that the nominal interest rate comprises of the real required rate of return and an inflation component.

Question 9

If a country's freely floating currency is undervalued in terms of purchasing power parity,its capital account is likely to be

Accepted Answer

If the currency is undervalued, then imports become more expensive for the country's residents while its exports become cheaper for foreign consumers. This leads to a higher demand for imports and lower demand for exports, resulting in a trade deficit. To finance this deficit, the country will need to borrow from foreign sources, which increases the capital account deficit or tendency toward a deficit.

Question 10

The theory of relative purchasing power parity states that,between two nations,the

Accepted Answer

The theory of relative purchasing power parity states that the exchange rate differential between two nations reflects the inflation rate differential. In other words, if one country experiences higher inflation than another, its currency should depreciate relative to the other country's currency to maintain parity in the purchasing power of the two currencies. This suggests that the exchange rate should move in the same direction as the inflation rate differential between two countries.

Question 11

What is the name of the theory that states exchange-adjusted prices on identical tradeable goods and financial assets must be within transaction costs of equality globally? The Law of

Accepted Answer

The theory described in the question is the Law of One Price, which states that exchange-adjusted prices for identical tradeable goods and financial assets must be equal or within transaction costs of equality across all markets globally.

Question 12

Suppose the expected inflation in the U.S.on January 1,1988 was projected at 5% annually for the next 5 years and at 12% annually in Italy for the same time period,and the lira/$ spot rate that day was currently at L2400 = $1,then the PPP estimate of the spot rate five years from now was

Accepted Answer

According to the PPP (Purchasing Power Parity) theory, the exchange rate between two countries should equal the ratio of the countries' price levels. In other words, the exchange rate should adjust for the inflation differential between the two countries.

Using this theory, we can estimate the future spot rate between the US and Italy as follows:

- First, we need to calculate the expected inflation differential between the two countries over the next 5 years:

US inflation rate = 5% annually for 5 years = 27.63% (using the formula: (1+5%)^5 - 1)
Italy inflation rate = 12% annually for 5 years = 79.58% (using the formula: (1+12%)^5 - 1)

- Next, we need to calculate the PPP-adjusted exchange rate between the US and Italy as of January 1, 1993 (5 years from now):

PPP-adjusted exchange rate = Spot rate * (1 + Italy inflation rate) / (1 + US inflation rate)
= 2400 * (1 + 79.58%) / (1 + 27.63%)
= 3313.86

Rounding to the nearest whole number gives us the answer of 3314, which is Choice B.

Question 13

Suppose annual inflation rates in the U.S.and Mexico are expected to be 6% and 80%,respectively,over the next several years.If the current spot rate for the Mexican peso is $.005,then the best estimate of the peso's spot value in 3 years is

Accepted Answer

We can use the formula for calculating the expected future spot rate:

Future Spot Rate = Spot Rate * ((1 + Foreign Interest Rate) / (1 + Domestic Interest Rate))^Time

Plugging in the given values, we get:

Future Spot Rate = 0.005 * ((1 + 0.8) / (1 + 0.06))^3
Future Spot Rate = 0.005 * 7.8536
Future Spot Rate = 0.03927

Therefore, the best estimate for the peso's spot value in 3 years is $0.00102, which is choice D.

Question 14

If the rate of inflation in all of the world's currency markets rises from 5% to 7%,this will tend to make forward exchange rates move toward

Accepted Answer

The answer of If the rate of inflation in all...

Question 15

In its absolute version,purchasing power parity states that price levels worldwide should be _______when expressed in a common currency.

Accepted Answer

Purchasing power parity in its absolute version states that price levels worldwide should be equal when expressed in a common currency.

Question 16

Which one of the following statements concerning exchange rate changes is correct?

Accepted Answer

Both expected and actual inflation can affect exchange rates as they impact a currency's purchasing power and attractiveness to investors. Higher inflation leads to a decrease in the value of a currency, thus leading to lower exchange rates.

Question 17

A 150% real return in Brazil is higher than a 15% dollar return in the U.S.

Accepted Answer

The distinction between nominal and real returns is crucial in comparing returns across different countries or currencies. A 150% real return accounts for inflation, meaning the actual purchasing power has increased by this percentage. A 15% dollar return could be nominal or real. If it's nominal, it doesn't account for inflation in the U.S., making the comparison with a real return in Brazil inappropriate without adjusting for inflation. If both are real returns, the comparison is valid, but the value of the returns still depends on the inflation rates and currency exchange rates between the two countries.

Question 18

When real interest rates are determined by the global supply and demand for funds,we claim that it is an example of

Accepted Answer

When the global supply and demand for funds determine real interest rates, it suggests that capital markets are integrated across countries. It means that investors from different countries can invest in the same markets, and their investments influence interest rates. This concept highlights the interconnectivity of the global economy, where capital flows freely between countries, and market participants react to global economic events.

Question 19

On January 1,1985,the annual inflation rates in the U.S.and France were expected to be 4% and 6%,respectively.If the current spot rate that day was $.1250,then the expected spot rate in two years was

Accepted Answer

Using the Relative Purchasing Power Parity (RPPP) formula, we have:
(1 + infl US)/(1 + infl France) = (Expected Spot Rate in 2 years)/(Current Spot Rate)
(1 + 0.04)/(1 + 0.06) = x/0.1250
x = 0.1203
Therefore, the expected spot rate in two years is $.1203, which corresponds to choice C.

Question 20

A rise in the inflation rate in one nation relative to others will be associated with a fall in the first nation's exchange rate and with a rise of its interest rate relative to foreign interest rates.The two conditions combined result in the _________ Effect.

Accepted Answer

This effect is known as the International Fisher Effect, which states that the difference in interest rates between two countries is equal to the expected change in their exchange rates. In other words, if a country's inflation rate is higher than others, its interest rate will also rise, causing its currency to depreciate in the long run. The International Fisher Effect is based on the concept of real interest rates, which take inflation into account.

Quiz 4: Parity Conditions in International Finance and Currency Forecasting