Question 1

The idea that with frictionless trade all goods traded internationally will have the same equilibrium price no matter which currency they are priced in is known as:

Accepted Answer

The concept of the law of one price states that in a frictionless market, identical goods should have the same price in different countries when the price is denominated in the same currency. This occurs due to arbitrage opportunities that allow traders to make profits by buying low-priced goods and selling them in regions where the same item is more costly. Covered interest parity refers to the idea that interest rate differentials should be equal to the forward exchange rate discount or premium. Relativity is a vague term and is not applicable in this context.

Question 2

If a pair of Nike shoes cost $45 in New York and $65 in Berlin, then we would expect the price to:

Accepted Answer

The law of one price states that identical goods should have the same price in different markets. Therefore, we would expect the price in New York to increase and the price in Berlin to decrease until they converge to a similar price.

Question 3

Purchasing power parity exists when: I. there are no arbitrage opportunities.
II) prices are the same when expressed in a common currency.
III) the goods in question are identical.

Accepted Answer

Purchasing power parity (PPP) exists when there are no arbitrage opportunities (meaning goods cannot be bought cheaply in one country and sold at a higher price in another), prices are the same when expressed in a common currency (indicating that exchange rates adjust to equalize the price of goods across countries), and the goods in question are identical (ensuring that price comparisons are for the same item, making the concept of PPP applicable).

Question 4

The real exchange rate between two currencies tells us:

Accepted Answer

The real exchange rate between two currencies tells us how much in terms of goods and services the home currency will buy in the foreign nation compared with the home nation. This takes into account the inflation rates in both countries, whereas the nominal exchange rate only reflects the exchange rate at a particular point in time.

Question 5

If a real exchange rate depreciation occurs, which of the following results?

Accepted Answer

A real exchange rate depreciation means that the home currency has lost value relative to a foreign currency, implying that more home goods are needed to purchase the same quantity of foreign goods.

Question 6

In equilibrium, all traded goods sell at the same price internationally because of:

Accepted Answer

Arbitrage refers to the practice of buying goods at a lower price in one market and immediately selling them in another market for a higher price, thus profiting from the price difference. In an international context, the existence of arbitrage opportunities ensures that prices of similar goods in different markets are equalized, as traders will quickly move to exploit any price differentials. This process helps to maintain equilibrium prices across borders, ensuring that goods sell at the same price internationally.

Question 7

In equilibrium, all traded goods sell at the same price internationally. If the same goods are expressed in their home prices, then the ratio of the prices is equal to:

Accepted Answer

In equilibrium, the law of one price holds, which means that all traded goods sell at the same price internationally. If the same goods are expressed in their home prices, then the ratio of the prices is equal to the nominal exchange rate between the two currencies. Therefore, choice D is the correct answer. The other options are incorrect as the ratio of prices would either be one (A) or zero (B), or related to the rate of interest (C), which is not necessarily relevant to the question.

Question 8

If an automobile costs $32,000 in New York and $1 = 0.8 euros, then under the condition of the law of one price, the cost of the automobile in Rome should be:

Accepted Answer

According to the law of one price, the cost in Rome should be the same as in New York when converted to euros. $32,000 * 0.8 euros/$ = 25,600 euros.

Question 9

The relative purchasing power of a currency is:

Accepted Answer

The relative purchasing power of a currency is the value of one currency in terms of the goods and services a unit will purchase compared with an equivalent amount of another currency. This takes into account the cost of living and the price levels in each country, making it a more accurate measure of the currency's purchasing power compared to other currencies.

Question 10

The monetary approach to exchange rates describes:

Accepted Answer

The monetary approach to exchange rates describes long-run relationships between money, prices, and exchange rates. It suggests that changes in money supply can affect the domestic price level, which in turn affects the exchange rate in the long run. The theory emphasizes the importance of fundamental economic variables in determining exchange rates over time.

Question 11

The law of one price requires:

Accepted Answer

The law of one price is based on the assumption of perfect competition, where there are no trade frictions such as transportation costs or government regulations that affect prices. Therefore, the best choice is B, as perfect competition is required for the law of one price to hold.

Question 12

If a pound of coffee beans costs 85 pesos in Mexico City and 10 pesos = 35 rupees, then the same pound of coffee should cost _________ rupees in New Delhi, under the condition of the law of one price.

Accepted Answer

The law of one price suggests that in the absence of transaction costs and assuming perfect market conditions, identical goods should have the same price when expressed in the same currency. To convert the cost from pesos to rupees, we use the given exchange rate: 10 pesos = 35 rupees. Therefore, 1 peso = 3.5 rupees. For a pound of coffee beans costing 85 pesos, the equivalent cost in rupees is 85 pesos * 3.5 rupees/peso = 297.5 rupees.

Question 13

In the international goods market, prices of goods in different countries expressed in a common currency must be equalized. This concept is called:

Accepted Answer

The law of one price states that the prices of identical goods in different countries must be equalized when expressed in a common currency. This is because if there is a difference in prices, traders will buy the good in the country where it is cheaper and sell it in the country where it is more expensive, thereby eliminating the price difference.

Question 14

When the price of a good in the United States is $2, while in Spain it is €2, and the nominal exchange rate is E_$/€= 1.5, what is the relative price of the good in Spain versus the United States?

Accepted Answer

The answer of When the price of a good in...

Question 15

The law of one price works under some assumptions. Which of the following is NOT an assumption for the law of one price?

Accepted Answer

The law of one price assumes that there are no barriers to trade, such as tariffs or transportation costs, and that there is free competition between buyers and sellers. However, it does not require that the skill level of workers be identical in different countries.

Question 16

If a basket of goods in the United States costs $1,000, and the same basket of goods in Japan costs ¥125,000, then for PPP to exist, $1 should trade for ____ Japanese yen.

Accepted Answer

PPP (Purchasing Power Parity) states that the exchange rate between two currencies should adjust to the price levels of a basket of goods and services in both countries. To determine the exchange rate between US dollars and Japanese yen, we need to divide the price level of the basket of goods in the US by the price level of the same basket of goods in Japan.

$1,000 / ¥125,000 = $0.008 / ¥1

Therefore, $1 should trade for ¥125, which is option C.

Question 17

While the law of one price relates prices on individual goods to the exchange rate, the theory of PPP relates:

Accepted Answer

The theory of PPP (Purchasing Power Parity) relates the relative price level of a basket of goods (or a measure of overall price levels) to the exchange rate. This means that the PPP theory suggests that, over time, the exchange rate between two currencies will adjust to reflect the differences in the price levels of a basket of goods between those two countries.

Question 18

The nominal exchange rate between two currencies tells us:

Accepted Answer

The nominal exchange rate between two currencies tells us how many units of one currency can be purchased with one unit of the home currency.

Question 19

Absolute purchasing power parity implies that:

Accepted Answer

Absolute purchasing power parity states that the price of a basket of goods should be the same in two countries after converting currencies. Therefore, the correct answer is that the price of a basket of goods is the same in the two countries.

Question 20

When the relative price of a good in Germany versus the United States is 3, if the nominal exchange rate is E_$/€= 1.5 and the U.S. price is $10, what is the German price?

Accepted Answer

Given, the relative price of a good in Germany versus the United States as 3 and the U.S. price as $10. Let the German price be x, then Relative price = (German price) / (U.S. price) 3 = x / $10 x = $30 Also, given the exchange rate as E_$/€= 1.5, which means 1 euro = $1.5 Therefore, German price = $30 = 30/1.5 = €20 Hence, the best choice is C.

Quiz 14: Exchange Rates I: the Monetary Approach in the Long Run