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Question 1

What is absolute purchasing power parity

Answer 1

The equilibrium exchange rate between two currencies
equals the ratio of national price levels in both nations.
S= P/P*

Question 2

What is the law of one price

Answer 2

A given commodity should have the same price (so
that the purchasing power of the two currencies is at
parity) in both countries when expressed in terms
of the same currency.
- Caused by commodity arbitrage.

Question 3

What is the need of ppp

Answer 3

• Exchange rates only reflect when goods are traded
• currencies are traded for reasons other than trade in goods and services
• speculation and interventions of interest rates can influence the FEM

Question 4

What is the purpose of PPP

Answer 4

Differences in living standards between nations
because PPP takes into account the relative cost of
living and the inflation rates of the countries,

Question 5

What is the assumption of PPP

Answer 5

In the absence of transportation and other
transaction costs, competitive markets will equalize
the price of an identical good in two countries when
the prices are expressed in the same currency

Question 6

Why does PPP fluctuate

Answer 6

PPP rate fluctuations are mostly due to different
rates of inflation in the two economies which would
result in the difference in prices at home and abroad

Question 7

Why can PPP theory be misleading

Answer 7

Appears to give exchange rate that equilibrates trade in
goods and services while ignoring capital account.- this is important as it determines the exchange rate
- At exchange rate that equilibrates trade in goods and
services, capital inflows would produce surplus in
balance of payments, while capital outflows would lead
to deficits
- Will not even give exchange rate that equilibrates trade
in goods and services because of existence of nontraded
goods.
- International trade tends to equalize prices of traded
goods and services, not nontraded goods.

Question 8

What is relative PPP

Answer 8

The change in the exchange rate over a period of
time should be proportional to the relative change
in the price levels of two nations over the same
time period.

Question 9

What is the equation of the relative PPP

Answer 9

S1 =
(P1 / P0//P1 / P0) x S0
where S1 and S0 = exchange rates in period 1 and base period
S = spot rate = ratio of price at home / ratio of price abroad x exchange rate

Question 10

Look at derivation of PPP on the slides

Question 11

How do you test PPP theory

Answer 11

-Plot actual inflation differentials and exchange rate
percentage changes for two or more countries on a
graph
- If the points deviate or ‘wander away’ significantly from
the PPP line over time, then PPP does not hold.

Question 12

Using a statistical test how do you test for PPP

Answer 12

• Apply regression analysis to historical exchange rates and inflation
  differentials:
• ef = a0 + a1 [ (1+Inflh)/(1+Inflf) – 1 ] + m
• Then apply t-tests to the regression coefficients. (Test for a0 = 0, and a1 =
  1.)
• If any coefficient differs significantly from what was expected, PPP
  does not hold

Question 13

What can inflation differentials forecast in the long run

Answer 13

Movments in the exchange rate especially large ones

Question 14

What do empirical studies on PPP show

Answer 14

indicate that the relationship between
inflation differentials and exchange rates is not perfec

Question 15

Why does PPP not occur

Answer 15

confounding effects
o Exchange rates are also affected by differences in
inflation, interest rates, income levels, government
controls and expectations of future rates
- there may be a lack of subs for certain traded goods

Question 16

When does PPP work well

Answer 16

• highly traded individual commodities
• over longer periods of time
• in cases of purely
  monetary disturbances
  and inflationary periods

Question 17

When does PPP work less well

Answer 17

• for all traded goods together
• for one or two decades
• in periods of monetary stability

Question 18

When does PPP not work well

Answer 18

• for all goods including non traded goods
• in the short run
• in situations of major structural change

Question 19

What is the fisher effect

Answer 19

Countries with higher inflation rates have higher interest
rates.

Question 20

What are the implications of the international fisheries effect

Answer 20

Currency with the lower interest rate is expected to
appreciate relative to the one with a higher rate.
- Financial market arbitrage ensures interest rate
differential is an unbiased predictor of change in future
spot rate

Question 21

What does the IFE state - and the equation

Answer 21

States that the spot rate adjusts to the interest
rate differential between two countries.
- IFE = PPP + FE
ഥ𝑒𝑡
𝑒0
=
(1 + 𝑟ℎ)𝑡 /
(1 + 𝑟𝑓)𝑡
- Where ഥ𝑒𝑡 is the expected exchange rate in period t.

Question 22

Simplified IFM

Answer 22

If 𝑟𝑓 is relatively small:

𝑟ℎ − 𝑟𝑓 =
𝑒1−𝑒0/ 𝑒0

Question 23

What is the law of one price

Answer 23

• A given commodity (one good ) should have the same price in both countries when expressed in terms of the same currency ( absence of transaction costs and trade barriers )
• caused by commodity arbiatge

Question 24

What happens is inflation is higher at home than in a foreign country

Answer 24

Then the consumers PPP Is grater in foreign goods than on home goods and vice versa
- it means PPP does not hold

Question 25

What does ef

Answer 25

The percentage change in forgiven currency should change to maintain parity in the new price indexes of the two countries