Topic 4 PPP and Fisher effect

Question 1

Assume a two-country world: Country A and Country B. Which of the following is correct about
purchasing power parity (PPP) as related to these two countries?
a. If Country A’s inflation rate exceeds Country B’s inflation rate, Country A’s currency will
weaken.
b. If Country A’s interest rate exceeds Country B’s inflation rate, Country A’s currency will
weaken.
c. If Country A’s interest rate exceeds Country B’s inflation rate, Country A’s currency will
strengthen.
d. If Country B’s inflation rate exceeds Country A’s inflation rate, Country A’s currency will
weaken.

Answer 1

a)

Question 2

Given a home country and a foreign country, purchasing power parity (PPP) suggests that:
a. a home currency will depreciate if the current home inflation rate exceeds the current
foreign interest rate.
b. a home currency will appreciate if the current home interest rate exceeds the current
foreign interest rate.
c. a home currency will appreciate if the current home inflation rate exceeds the current
foreign inflation rate.
d. a home currency will depreciate if the current home inflation rate exceeds the current
foreign inflation rate.

Answer 2

d)

Question 3

The international Fisher effect (IFE) suggests that:
a. a home currency will depreciate if the current home interest rate exceeds the current
foreign interest rate.
b. a home currency will appreciate if the current home interest rate exceeds the current
foreign interest rate.
c. a home currency will appreciate if the current home inflation rate exceeds the current
foreign inflation rate.
d. a home currency will depreciate if the current home inflation rate exceeds the current
foreign inflation rate.

Answer 3

a)? - b)

Question 4

Because there are a variety of factors in addition to inflation that affect exchange rates, this will:
a. reduce the probability that PPP shall hold.
b. increase the probability that PPP shall hold.
c. increase the probability the IFE will hold.
d. B and C

Answer 4

a)

Question 5

Because there are sometimes no substitutes for traded goods, this will:
a. reduce the probability that PPP shall hold.
b. increase the probability that PPP shall hold.
c. increase the probability the IFE will hold.
d. B and C

Answer 5

a)

Question 6

According to the IFE, if British interest rates exceed Australian interest rates:
a. the British pound’s value will remain constant.
b. the British pound will depreciate against the Australian dollar.
c. the British inflation rate will decrease.
d. the forward rate of the British pound will contain a premium.
e. today’s forward rate of the British pound will equal today’s spot rate.

Answer 6

b)

Question 7

Given a home country and a foreign country, the international Fisher effect (IFE) suggests that:
a. the nominal interest rates of both countries are the same.
b. the inflation rates of both countries are the same.
c. the exchange rates of both countries will move in a similar direction against other
currencies.
d. none of the above

Answer 7

d)

Question 8

Given a home country and a foreign country, purchasing power parity suggests that:
a. the inflation rates of both countries will be the same.
b. the nominal interest rates of both countries will be the same.
c. A and B
d. none of the above

Answer 8

d)

Question 9

If interest rates on the euro are consistently below Australian interest rates, then for the international
Fisher effect (IFE) to hold:
a. the value of the euro would often appreciate against the Australian dollar.
b. the value of the euro would often depreciate against the Australian dollar.
c. the value of the euro would remain constant most of the time.
d. the value of the euro would appreciate in some periods and depreciate in other periods, but
on average have a zero rate of appreciation.

Answer 9

a)

Question 10

If the international Fisher effect (IFE) did not hold based on historical data, then this suggests that:
a. some corporations with excess cash can lock in a guaranteed higher return on future
foreign short-term investments.
b. some corporations with excess cash could have generated profits on average from covered
interest arbitrage.
c. some corporations with excess cash could have generated higher profits on average from
foreign short-term investments than from domestic short-term investments.
d. most corporations that consistently invest in foreign short-term investments would have
generated the same profits (on average) as from domestic short-term investments.

Answer 10

c)