International Economics, 7e (Husted/Melvin)
Chapter 14 Prices and Exchange Rates: Purchasing Power Parity
Multiple-Choice Questions
1) For which of the following will the law of one price hold best?
A) shirt
B) butter
C) gold
D) milk
Answer: C
2) Changes in exchange rates are due to
A) real events only.
B) nominal events only.
C) both real and nominal events.
D) None of the above.
Answer: C
3) Relative price changes indicate
A) all prices move together.
B) all exchange rates move together.
C) some prices increase faster than others.
D) exchange rates appreciate faster than prices change.
Answer: C
4) Arbitrage operations can be executed
A) in foreign exchange markets.
B) in goods markets.
C) Both A and B.
D) None of the above.
Answer: C
5) We can expect deviations from PPP because of
A) quotas and tariffs.
B) transportation costs.
C) differentiated goods.
D) All of the above.
Answer: D
6) Over a short-run period (i.e., week or month), ________ dominate exchange rate movements.
A) short-run inflation differentials
B) nominal price changes
C) relative price changes
D) None of the above
Answer: C
1
7) In the long run, ________ dominate exchange rate movements.
A) short-run inflation differentials
B) long-run inflation differentials
C) short-run relative price changes
D) All of the above
Answer: B
8) PPP holds better for ________ countries.
A) low-inflation
B) poor
C) rich
D) high-inflation
Answer: D
9) We expect PPP to hold better
A) for annual data than monthly data.
B) for high-inflation countries.
C) in the long run.
D) All of the above.
Answer: D
10) Which of the following is incorrect?
A) Exchange rates in the short run are much more variable than inflation differentials.
B) Deviations from PPP are much more apparent for monthly data than annual.
C) PPP holds best in the long run.
D) None of the above.
Answer: D
11) If American and Japanese consumers buy the same basket of goods in each country and
there is no inflation in either country,
A) the law of one price will hold.
B) deviations from PPP will occur.
C) PPP will hold.
D) Both A and C.
Answer: D
12) Which of the following statements is correct?
A) PPP is a theory of exchange rate determination.
B) Inflation differentials cause changes in exchange rates.
C) PPP is an equilibrium relationship between two endogenous variables.
D) PPP, or the law of one price, should hold well for individual goods.
Answer: C
13) Evidence suggests that, following some exogenous shock, exchange rates change
A) before prices change.
B) after prices change.
C) at the same time prices change.
D) None of the above.
Answer: A
2
14) Deviations from PPP
A) may be due to the differential speed of adjustment between exchange rates and prices.
B) may occur when international trade involves lags between order and delivery.
C) may appear during periods dominated by news or unexpected events.
D) All of the above.
Answer: D
15) Relative PPP indicates that
A) the exchange rate between any two currencies is equal to the ratio of their price
indexes.
B) the same good sells for the same price internationally.
C) the percentage change in the exchange rate is equal to the inflation differential between
the domestic and foreign country.
D) relative prices determine exchange rates.
Answer: C
16) If the exchange rate is equal to the ratio of the domestic and foreign price indexes,
A) absolute PPP holds.
B) relative PPP holds.
C) one currency is said to be overvalued.
D) one currency is said to be undervalued.
Answer: A
17) If the dollar appreciates against the Canadian dollar at a faster rate than the Canadian
inflation rate exceeds the U.S. rate, then the U.S. dollar appears
A) depreciated.
B) overvalued.
C) undervalued.
D) None of the above.
Answer: B
18) The law of one price should hold well for
A) differentiated products.
B) any individual goods traded internationally.
C) homogeneous goods.
D) All of the above.
Answer: C
19) If absolute PPP held, then the real exchange rate must be equal to
A) a constant.
B) one.
C) zero.
D) a positive number.
Answer: B
3
20) The domestic currency is said to be ________ if it has appreciated at a lower rate than the
difference between the domestic inflation rate and the higher foreign inflation rate.
A) undervalued
B) overvalued
C) appreciated
D) risky
Answer: A
True or False Questions
1) The more homogeneous goods are, the more we expect the law of one price not to hold.
Answer:
False
Explanation: It is expected to hold better for homogeneous goods.
2) If absolute PPP holds, then relative PPP will also hold.
Answer:
True
Explanation: If the levels of the variables (prices and exchange rates) hold, then changes in
these variables should hold as well. But, not vice-versa.
3) The only reason that exchange rates change is because overall price levels in the countries
change.
Answer:
False
Explanation: Relative price changes, in addition to inflation, can change the exchange rates.
4) We expect that in the long run, exchange rate movements will largely reflect inflation
differentials.
Answer:
True
Explanation: Because real events causing relative price movements are often random and short
run in nature.
5) PPP holds better for low-inflation countries.
Answer:
False
Explanation: Opposite, in high-inflation countries changes in exchange rates are highly
correlated with inflation differentials because the sheer magnitude of inflation
overwhelms the relative price effects.
6) Studies of PPP covering many years will be more likely to yield evidence of PPP than studies
based on short-run data.
Answer:
True
Explanation: The longer time frame will allow for more inflation so that the random relative
price effects are relatively unimportant and we find exchange rate changes closely
related to inflation differentials.
7) The empirical data indicate that in the short run exchange rates are much more variable than
inflation differentials.
Answer:
True
Explanation: None Given
4
8) If the law of one price holds for a single good, then absolute PPP measured with price
indexes will also hold.
Answer:
False
Explanation: Since consumers in different countries consume different goods, price indexes are
not directly comparable internationally. Thus using price indexes to measure PPP
creates problems and causes deviations from PPP.
9) PPP is a theory of exchange rate determination.
Answer:
False
Explanation: It is only an equilibrium relationship between two endogenous variables. Prices
and exchange rates are simultaneously determined by other factors such that the
former do not cause the latter to change.
10) If relative PPP held, then the real exchange rate must be equal to one.
Answer:
False
Explanation: If relative PPP held, then the real exchange rate must be equal to a constant
number.
Essay Questions
1) Briefly explain the difference between absolute and relative PPP.
Answer: Absolute PPP deals with levels of variables while relative PPP deals with changes in
these variables. Therefore absolute PPP says that the exchange rate between any two
currencies is equal to the ratio of their price indexes while relative PPP indicates that
the percentage change in the exchange rate is equal to the inflation differentials
between the countries.
2) Empirical studies find that exchange rates are much more variable than inflation
differentials. How can we explain this empirical result?
Answer: Financial markets adjust faster than goods market. Therefore, for any exogenous
shock or news, we expect exchange rates to change faster than prices. Thus the
differential speed of adjustment makes exchange rates much more variable.
3) Suppose that you desperately need a grade of "A" from your International Finance course
and further suppose that it depends upon the grade that you will get from the term paper
that you write on PPP. Let's assume that you know that your teacher believes that PPP
holds anytime anywhere. What kind of evidence would you submit that would indicate that
PPP holds? In other words, what kind of countries and data would you choose for your
analysis to bias the empirical results regarding PPP?
Answer: Choose the data from:
∙ high inflation countries with diversified trade (i.e., open economy)
∙ annual data
∙ countries with less-developed financial markets (i.e., LDCs)
5
4) Is PPP a theory of exchange rate determination? Explain why or why not?
Answer: PPP is not a theory of exchange rate determination. It describes an equilibrium
relationship between two endogenous variables prices and exchange rates. As such,
the PPP relationship should be viewed as a short-cut rather than a substitute for a
complete determination of prices and exchange rates. Its main usefulness is in
providing a guide to the general trend of exchange rates rather than day-to-day
fluctuations.
5) What are the main reasons for deviations from PPP? Give, at least, 5 reasons with a short
explanation.
Answer: ∙ The presence of non-traded goods prices in price indexes
∙ Financial asset prices adjust faster than goods prices due to the slow adjustment in
goods markets
∙ Relative price changes
∙ Different consumption bundles across countries
∙ Differentiated goods
∙ Shipping costs, tariffs
∙ News, unexpected events
6) Explain briefly what an "overvalued" currency is. Would you change your explanation
depending upon whether or not there is central bank intervention or not? Discuss.
Answer: ∙ In the case of no intervention (i.e., pure flexible exchange rate regime) the exchange
rate is actually the free-market equilibrium rate. Then the term "overvalued" implies
that this equilibrium is but a temporary deviation from PPP, and over time the
exchange rate will fall in line with the inflation differential.
∙ In the case of central bank intervention we can talk about a currency being
overvalued or undervalued relative to the free market since this intervention
interrupts the free adjustment of the exchange rate to market clearing levels.
∙ Because PPP does not hold well in the short run, we must always have currencies
that appear "overvalued" or "undervalued" in a PPP sense.
7) The establishment of the Euro as a unit of account in 1999 meant that from then on the
currencies of the participating countries traded at a fixed rate, until the Euro completely
replaced these currencies in the year 2002.
(a) How would the inflation rates of these countries have to had been in these transition
years for PPP to hold?
(b) If the inflation of Italy was twice as high as that of Germany a year between 1999 and
2002, what can we say then about the Italian lira against the German mark?
(c) What does the concept of PPP thus tells us about what needs to happen for such this
monetary agreement to work for a long period of time?
Answer: (a) The inflation rates of the participating countries must be equal for PPP to hold. (b)
The Italian lira became overvalued with respect to the German mark and the other
currencies.
(c) Given that the exchange rates are fixed, the concept of PPP tells us that for a longrun equilibrium to hold among these countries, the inflation rates must be the same.
Once the euro replaced the old individual currencies, the newly formed European
central bank now handles the monetary policy of all the participating countries, so
that PPP will hold, just like it does for the different states of the U. S..
6