Question 1

Which of the following theories can be assessed using data that exists at one specific point in time?

Accepted Answer

Interest rate parity (IRP) is the theory that the difference in interest rates between two countries will be equal to the difference between the forward exchange rate and the spot exchange rate. This theory can be assessed using data that exists at one specific point in time. Conversely, purchasing power parity (PPP) and the international Fisher effect (IFE) rely on data over a period of time, making them difficult to assess at one specific point in time.

Question 2

There is much evidence to suggest that Japanese investors invest in U.S. Treasury securities when U.S. interest rates are higher than Japanese interest rates. These investors most likely believe in the international Fisher effect.

Accepted Answer

The answer of There is much evidence to suggest that...

Question 3

Interest rate parity can only hold if purchasing power parity holds.

Accepted Answer

Purchasing power parity relates to the relative price levels of two currencies, while interest rate parity relates to the relationship between interest rates and exchange rates. While the two concepts are related, they are distinct and one does not necessarily depend on the other.

Question 4

Research indicates that deviations from purchasing power parity (PPP) are reduced over the long run.

Accepted Answer

Long-term evidence suggests that the law of one price tends to hold, and deviations from PPP are reduced over time as markets adjust. This adjustment process can take years or even decades, but eventually leads to a convergence of prices across countries.

Question 5

According to the international Fisher effect (IFE), the exchange rate percentage change should be approximately equal to the differential in income levels between two countries.

Accepted Answer

The international Fisher effect (IFE) states that the exchange rate percentage change should be approximately equal to the differential in nominal interest rates between two countries, not income levels.

Question 6

Which of the following is not true regarding IRP, PPP, and the IFE?

Accepted Answer

IRP (Interest Rate Parity) does not suggest that a currency's spot rate will change according to interest rate differentials; rather, it suggests that the forward exchange rate should offset interest rate differentials to prevent arbitrage.

Question 7

The following regression analysis was conducted for the inflation rate information and exchange rate of the British pound: $e _ { B P } = a _ { 0 } + a _ { 1 } \left( \frac { \left( 1 + I _ { U S } \right) } { \left( 1 + I _ { B } \right) } - 1 \right) + \mu$ Regression results indicate that a₀ = 0 and a₁ = 2. Therefore:

Accepted Answer

The regression coefficient for inflation rate differential is positive (a₁=2), indicating that the exchange rate of the British pound did not fully adjust to changes in inflation rates, and therefore, purchasing power parity underestimated the exchange rate change during the period under examination. This means that the actual exchange rate change was more significant than what was predicted by purchasing power parity. Therefore, the correct answer is C. Option A is incorrect because the regression results do not indicate that purchasing power parity holds. Option B and D are incorrect because the regression results do not provide information about over- or underestimation of the exchange rate change during future periods.

Question 8

Assume that the U.S. inflation rate is higher than the New Zealand inflation rate. This will cause U.S. consumers to ____ their imports from New Zealand and New Zealand consumers to ____ their imports from the U.S. According to purchasing power parity (PPP), this will result in a(n) ____ of the New Zealand dollar (NZ$).

Accepted Answer

Higher U.S. inflation makes U.S. goods more expensive relative to New Zealand goods, leading U.S. consumers to increase imports from New Zealand. Conversely, New Zealand consumers will reduce imports from the U.S. due to relatively higher prices. According to PPP, this will lead to an appreciation of the New Zealand dollar.

Question 9

If nominal British interest rates are 3% and nominal U.S. interest rates are 6%, then the British pound (£) is expected to ____ by about ____%, according to the international Fisher effect (IFE).

Accepted Answer

(1.06/1.03) - 1 = 2.9%.

Question 10

Which of the following is indicated by research regarding purchasing power parity (PPP)?

Accepted Answer

Research indicates that deviations from PPP are reduced in the long run. While PPP may not hold perfectly in the short run, it is believed to hold over longer periods of time as exchange rates adjust to reflect inflation differentials. Therefore, option B is the best choice. Option A is incorrect because PPP does not hold clearly in the short run. Option C is incorrect because PPP may not hold clearly in the long run. Option D is incorrect because there is a relationship between inflation differentials and exchange rate movements in the long run, which is what PPP is based on.

Question 11

The interest rate in the U.K. is 7%, while the interest rate in the U.S. is 5%. The spot rate for the British pound is $1.50. According to the international Fisher effect (IFE), the British pound should adjust to a new level of:

Accepted Answer

SOLUTION:(1.05/1.07) × (1.50) = $1.47.

Question 12

The IFE theory suggests that foreign currencies with relatively high interest rates will appreciate because the high nominal interest rates reflect expected inflation.

Accepted Answer

The International Fisher Effect (IFE) theory suggests that currencies with higher interest rates will depreciate, as the high rates reflect expected inflation, leading to a decrease in the currency's value.

Question 13

If interest rate parity holds, then the international Fisher effect must hold.

Accepted Answer

Interest rate parity and the international Fisher effect are related but distinct concepts. Interest rate parity focuses on the relationship between interest rates and exchange rates, while the international Fisher effect relates interest rates to expected inflation rates. They do not necessarily imply each other.

Question 14

If interest rate parity holds, and the international Fisher effect (IFE) holds, foreign currencies with relatively high interest rates should have forward discounts and those currencies would be expected to depreciate.

Accepted Answer

If interest rate parity holds, it means that the difference in interest rates between two countries should be equal to the difference in their exchange rates. The international Fisher effect (IFE) states that the difference in interest rates between two countries should be reflected in the expected change in their exchange rates. Therefore, if a foreign currency has a relatively high interest rate, it should have a forward discount (a lower exchange rate in the future) according to interest rate parity and the IFE. This means that the currency would be expected to depreciate in value.

Question 15

Which of the following theories suggests that the percentage change in spot exchange rate of a currency should be equal to the inflation differential between two countries?

Accepted Answer

This is the definition of purchasing power parity theory which suggests that in the long run, exchange rates will adjust to reflect the inflation differential between two countries.

Question 16

Which of the following theories suggests that the percentage difference between the forward rate and the spot rate depends on the interest rate differential between two countries?

Accepted Answer

The theory of interest rate parity (IRP) suggests that the percentage difference between the forward rate and spot rate is equal to the interest rate differential between two countries. This is because the forward exchange rate is determined by the spot rate and the interest rate differential. A higher interest rate in one country will attract more foreign capital, causing an increase in demand for that country's currency and a rise in the exchange rate. Therefore, IRP suggests that the forward exchange rate should reflect the expected changes in exchange rates due to the interest rate differential, which ultimately depends on supply and demand for currency.

Question 17

The inflation rate in the U.S. is 3%, while the inflation rate in Japan is 10%. The current exchange rate for the Japanese yen (¥) is $0.0075. After supply and demand for the Japanese yen has adjusted in the manner suggested by purchasing power parity, the new exchange rate for the yen will be:

Accepted Answer

SOLUTION:(1.03/1.10) × $.0075 = $.0070

Question 18

The relative form of purchasing power parity (PPP) accounts for the possibility of market imperfections such as transportation costs, tariffs, and quotas in establishing a relationship between inflation rates and exchange rate changes.

Accepted Answer

The statement is true. The relative form of PPP takes into account market imperfections that may affect the prices of goods and services in different countries, and adjust for these imperfections in establishing a relationship between inflation rates and exchange rates. This can lead to a more accurate estimation of exchange rate movements based on fundamental economic factors.

Question 19

If the IFE theory holds, that means that covered interest arbitrage is not feasible.

Accepted Answer

The International Fisher Effect (IFE) theory relates to the expected change in exchange rates based on interest rate differentials, while covered interest arbitrage involves exploiting differences in interest rates between countries while hedging exchange rate risk. They address different aspects of international finance.

Question 20

Assume that the inflation rate in Singapore is 3%, while the inflation rate in the U.S. is 8%. According to PPP, the Singapore dollar should ____ by ____%.

Accepted Answer

SOLUTION:
(1.08/1.03) - 1 = 4.85%.

Quiz 8: Relationships among Inflation, Interest Rates, and Exchange Rates

Which of the following theories can be assessed using data that exists at one specific point in time?

There is much evidence to suggest that Japanese investors invest in U.S. Treasury securities when U.S. interest rates are higher than Japanese interest rates. These investors most likely believe in the international Fisher effect.

Interest rate parity can only hold if purchasing power parity holds.

Research indicates that deviations from purchasing power parity (PPP) are reduced over the long run.

According to the international Fisher effect (IFE), the exchange rate percentage change should be approximately equal to the differential in income levels between two countries.

Which of the following is not true regarding IRP, PPP, and the IFE?

If nominal British interest rates are 3% and nominal U.S. interest rates are 6%, then the British pound (£) is expected to by about %, according to the international Fisher effect (IFE) .

Which of the following is indicated by research regarding purchasing power parity (PPP) ?

The interest rate in the U.K. is 7%, while the interest rate in the U.S. is 5%. The spot rate for the British pound is $1.50. According to the international Fisher effect (IFE) , the British pound should adjust to a new level of:

The IFE theory suggests that foreign currencies with relatively high interest rates will appreciate because the high nominal interest rates reflect expected inflation.

If interest rate parity holds, then the international Fisher effect must hold.

If interest rate parity holds, and the international Fisher effect (IFE) holds, foreign currencies with relatively high interest rates should have forward discounts and those currencies would be expected to depreciate.

Which of the following theories suggests that the percentage change in spot exchange rate of a currency should be equal to the inflation differential between two countries?

Which of the following theories suggests that the percentage difference between the forward rate and the spot rate depends on the interest rate differential between two countries?

The inflation rate in the U.S. is 3%, while the inflation rate in Japan is 10%. The current exchange rate for the Japanese yen (¥) is $0.0075. After supply and demand for the Japanese yen has adjusted in the manner suggested by purchasing power parity, the new exchange rate for the yen will be:

The relative form of purchasing power parity (PPP) accounts for the possibility of market imperfections such as transportation costs, tariffs, and quotas in establishing a relationship between inflation rates and exchange rate changes.

If the IFE theory holds, that means that covered interest arbitrage is not feasible.

Assume that the inflation rate in Singapore is 3%, while the inflation rate in the U.S. is 8%. According to PPP, the Singapore dollar should by %.

Quiz 8: Relationships among Inflation, Interest Rates, and Exchange Rates

Which of the following theories can be assessed using data that exists at one specific point in time?

There is much evidence to suggest that Japanese investors invest in U.S. Treasury securities when U.S. interest rates are higher than Japanese interest rates. These investors most likely believe in the international Fisher effect.

Interest rate parity can only hold if purchasing power parity holds.

Research indicates that deviations from purchasing power parity (PPP) are reduced over the long run.

According to the international Fisher effect (IFE), the exchange rate percentage change should be approximately equal to the differential in income levels between two countries.

Which of the following is not true regarding IRP, PPP, and the IFE?

If nominal British interest rates are 3% and nominal U.S. interest rates are 6%, then the British pound (£) is expected to ____ by about ____%, according to the international Fisher effect (IFE) .

Which of the following is indicated by research regarding purchasing power parity (PPP) ?

The interest rate in the U.K. is 7%, while the interest rate in the U.S. is 5%. The spot rate for the British pound is $1.50. According to the international Fisher effect (IFE) , the British pound should adjust to a new level of:

The IFE theory suggests that foreign currencies with relatively high interest rates will appreciate because the high nominal interest rates reflect expected inflation.

If interest rate parity holds, then the international Fisher effect must hold.

If interest rate parity holds, and the international Fisher effect (IFE) holds, foreign currencies with relatively high interest rates should have forward discounts and those currencies would be expected to depreciate.

Which of the following theories suggests that the percentage change in spot exchange rate of a currency should be equal to the inflation differential between two countries?

Which of the following theories suggests that the percentage difference between the forward rate and the spot rate depends on the interest rate differential between two countries?

The inflation rate in the U.S. is 3%, while the inflation rate in Japan is 10%. The current exchange rate for the Japanese yen (¥) is $0.0075. After supply and demand for the Japanese yen has adjusted in the manner suggested by purchasing power parity, the new exchange rate for the yen will be:

The relative form of purchasing power parity (PPP) accounts for the possibility of market imperfections such as transportation costs, tariffs, and quotas in establishing a relationship between inflation rates and exchange rate changes.

If the IFE theory holds, that means that covered interest arbitrage is not feasible.

Assume that the inflation rate in Singapore is 3%, while the inflation rate in the U.S. is 8%. According to PPP, the Singapore dollar should ____ by ____%.

If nominal British interest rates are 3% and nominal U.S. interest rates are 6%, then the British pound (£) is expected to by about %, according to the international Fisher effect (IFE) .

Assume that the inflation rate in Singapore is 3%, while the inflation rate in the U.S. is 8%. According to PPP, the Singapore dollar should by %.