int'l parity conditions (lecture #11)

Question 1

what happens with a fixed exchange rate in terms of government intervention?

Answer 1

if demand for currency is going, gov. will intervene to increase supply

-this causes foreign exchange reserves to increase because the ‘home’ country is selling their currency, and getting new currency

Question 2

def. law of one price

Answer 2

states that all else being equal (no transaction costs or restrictions) a product’s price should be the same in all markets

Question 3

regarding PPP, what would happen if the law of one price were true for all goods

Answer 3

the PPP exchange rate could be found from any set of prices

Question 4

what is the absolute theory of purchasing power parity

Answer 4

absolute PPP states that the spot exchange rate is determined by the relative prices of similar basket of goods

Question 5

describe the “Big Mac Index”

Answer 5

• prime example of the law of one price
• assuming that the Big Mac is identical in all countries
• serves as a comparison point as to whether or not currencies are trading at market prices

Question 6

what do empirical tests of both relative and absolute PPP show

Answer 6

• PPP tends to not be accurate in predicting future exchange rates
• PPP holds up well over the very long term but is poor for short term estimates
• the theory holds better for countries with relatively high rates of inflation and underdeveloped capital markets