Question 1

Which of the following is referred to as the purchasing power parity puzzle?

Accepted Answer

The failure to find a strong link between relative inflation rates and exchange rate movements has been referred to as the purchasing power parity puzzle.

Question 2

Assume that the law of one price holds. A shirt that retails for $120 in New York sells for £60 in London. The exchange rate between the British pound and the dollar is £1 = $1.50. Assuming away transportation costs and trade barriers, this creates a profit-making opportunity called

Accepted Answer

Arbitrage involves the purchase and sale of a commodity at the same time to take advantage of pricing differentials in two markets.

Question 3

Suppose the price of a Big Mac in New York is $3.00 and the price of a Big Mac in Paris is equivalent to $3.75 at the prevailing euro/dollar exchange rate. Using the concept of purchasing power parity, the euro is

Accepted Answer

According to the PPP theory, the prices in the two countries should be the same. If they are not, it implies that the currency is either overvalued against the dollar or undervalued.

Question 4

Which of the following occurs when the quantity of money in circulation in a country rises faster than the country's stock of goods and services?

Accepted Answer

Inflation occurs when the quantity of money in circulation rises faster than the stock of goods and services; that is, when the money supply increases faster than output increases.

Question 5

The ________ states that in competitive markets free of transportation costs and barriers to trade, identical products sold in different countries must sell for the same price when their price is expressed in terms of the same currency.

Accepted Answer

The law of one price states that in competitive markets free of transportation costs and barriers to trade (such as tariffs), identical products sold in different countries must sell for the same price when their price is expressed in terms of the same currency. It helps us to understand how prices are related to exchange rate movements.

Question 6

The ________ school of thought argues that forward exchange rates do the best possible job of forecasting future spot rates and therefore investing in forecasting services would be a waste of money.

Accepted Answer

The efficient market school argues that forward exchange rates do the best possible job of forecasting future spot exchange rates, and, therefore, investing in forecasting services would be a waste of money.

Question 7

________ draws on economic theory to construct sophisticated econometric models for predicting exchange rate movements.

Accepted Answer

Fundamental analysis draws on economic theory to construct sophisticated econometric models for predicting exchange rate movements.

Question 8

The ________ states that a country's "nominal" interest rate is the sum of the required "real" rate of interest and the expected rate of inflation over the period for which the funds are to be lent.

Accepted Answer

The Fisher Effect states that a country's "nominal" interest rate (i) is the sum of the required "real" rate of interest (r) and the expected rate of inflation over the period for which the funds are to be lent (I). (i = r + I)

Question 9

The ________ suggests that given relatively efficient markets, the price of a "basket of goods" should be roughly equivalent in each country.

Accepted Answer

If the law of one price were true for all goods and services, the PPP exchange rate could be found from any individual set of prices. By comparing the prices of identical products in different currencies, it would be possible to determine the "real" or PPP exchange rate that would exist if markets were efficient.

Question 10

According to the law of one price, if the exchange rate between the British pound and the dollar is £1 = $1.50, a shirt that retails for $120 in New York should sell for ________ in London.

Accepted Answer

The shirt will sell for £80 (120 ÷ 1.5). The law of one price states that in competitive markets free of transportation costs and barriers to trade, identical products sold in different countries must sell for the same price when their price is expressed in terms of the same currency.

Question 11

Identify the correct statement about the PPP theory.

Accepted Answer

While PPP theory seems to yield relatively accurate predictions in the long run, it does not appear to be a strong predictor of short-run movements in exchange rates covering time spans of five years or less.

Question 12

If a country has an externally convertible currency

Accepted Answer

A currency is said to be externally convertible when only nonresidents may convert it into a foreign currency without any limitations.

Question 13

The ________ states that, for any two countries, the spot exchange rate should change in an equal amount but in the opposite direction to the difference in nominal interest rates between the two countries.

Accepted Answer

The International Fisher Effect states that for any two countries, the spot exchange rate should change in an equal amount but in the opposite direction to the difference in nominal interest rates between the two countries.

Question 14

A(n) ________ is one in which prices do not reflect all available information.

Accepted Answer

An inefficient market is one in which prices do not reflect all available information. In an inefficient market, forward exchange rates will not be the best possible predictors of future spot exchange rates.

Question 15

If the demand for dollars outstrips its supply and if the supply of Japanese yen is greater than the demand for it, what will happen?

Accepted Answer

At the most basic level, exchange rates are determined by the demand and supply of one currency relative to the demand and supply of another.

Question 16

With which of the following would a follower of the inefficient market school of thought agree

Accepted Answer

The inefficient market school argues that companies can improve the foreign exchange market's estimate of future exchange rates (as contained in the forward rate) by investing in forecasting services.

Question 17

Which of the following occurs when traders start moving as a herd in the same direction at the same time?

Accepted Answer

The bandwagon effect occurs when traders start moving as a herd in the same direction at the same time.

Question 18

________ uses price and volume data to determine past trends, which are expected to continue into the future.

Accepted Answer

Technical analysis is based on the premise that there are analyzable market trends and waves and that previous trends and waves can be used to predict future trends and waves.

Question 19

A currency is said to be freely convertible when

Accepted Answer

A country's currency is said to be freely convertible when the country's government allows both residents and nonresidents to purchase unlimited amounts of a foreign currency with it.

Question 20

It follows from the Fisher Effect that if the real interest rate is the same worldwide, any difference in interest rates between countries reflects differing expectations about

Accepted Answer

It follows from the Fisher Effect that if the real interest rate is the same worldwide, any difference in interest rates between countries reflects differing expectations about inflation rates.

Quiz 10: The Foreign Exchange Market