Chapter 8 (Final Exam)

Question 1

What does the Purchasing Power Parity (PPP) theory explain?

Answer 1

It explains the relationship between inflation rates and exchange rates, suggesting that exchange rates adjust to equalize the price of goods across countries.

Question 2

Note:

Answer 2

% change in exchange rate should be approx equal to the difference in inflation rate between 2 countries

Question 3

What are the two forms of PPP?

Answer 3

Absolute PPP: Prices of identical products in different countries should be equal when expressed in a common currency.
Relative PPP: Exchange rates adjust to reflect differences in inflation rates between countries.
(Exchange rate in prices should be similar)

Question 4

What happens if a country’s inflation rate is higher than another’s, according to PPP?

Answer 4

The currency of the country with higher inflation will depreciate relative to the other country’s currency.

Question 5

If ih>if

Answer 5

Then, ef (Derivation of PPP) should be +, foreign currency appreciates

Question 6

ih<if

Answer 6

Then, ef (Derivation of PPP) should be -, foreign currency deppreciates

Question 7

How can PPP be used to estimate exchange rate changes?

Answer 7

By comparing the inflation rate differences between two countries

Question 8

PPP Line

Answer 8

Diagonal line connecting all points together

Question 9

What is the International Fisher Effect (IFE)?

Answer 9

It states that currencies with higher nominal interest rates will depreciate because higher rates reflect higher expected inflation.

Question 10

How does IFE affect investors?

Answer 10

Investors earn similar returns on domestic and foreign investments after accounting for currency depreciation.

Question 11

How are PPP and IFE connected?

Answer 11

Both involve inflation: PPP focuses on how inflation differences affect exchange rates, while IFE links interest rates to inflation and exchange rates.

Question 12

What are the limitations of PPP?

Answer 12

-Exchange rates are affected by more than inflation (e.g., income levels, interest rates, government controls & expectations).
-Not all goods have substitutes, so trade may not equalize prices.

Question 13

What are the limitations of IFE?

Answer 13

-The actual inflation rate may differ from expected inflation.
-High interest rates in a country can attract capital, strengthening its currency instead of causing depreciation.

Question 14

What happens if PPP or IFE does not hold in reality?

Answer 14

Investment in foreign securities may yield higher or lower returns than domestic investments, depending on exchange rate movements.