HOMEWORK 8 (CHAPTER 16 PRICE LEVELS AND THE EXCHANGE RATE IN THE LONG RUN) ECO41 FALL
2015 UDAYAN ROY
Each correct answer is worth 1 point. The maximum score is 20 points. This homework is due in class
on Wednesday, December 2. Please show your answers on the answer sheet (on the last page).
1. Which of the following statements is the most accurate expression of the law of one price (also
known as absolute purchasing power parity)?
a. In competitive markets free of transportation costs and official barriers to trade, identical goods
sold in the same country must sell for the same price when their prices are expressed in the
same currency.
b. In competitive markets free of transportation costs and official barriers to trade, identical goods
sold in different countries must sell for the same price.
c. In competitive markets free of transportation costs and official barriers to trade, identical goods
sold in different countries must sell for the same price when their prices are expressed in the
same currency.
d. Identical goods sold in different countries must sell for the same price when their prices are
expressed in the same currency.
e. None of the above
2. Let E$/€ be the dollars-per-euro exchange value of the euro, and let PUS and PE be the overall price
levels in USA and Europe, respectively. Under absolute purchasing power parity,
a.
b.
c.
d.
e.
E$/€ = PE/PES
E$/€ = PUS + PE
E$/€ = PUS/PE
E$/€ = PUS – PE
None of the above.
3. Absolute purchasing power parity is the assumption that
a. The domestic price level (P) is equal to the foreign price level (P*) once foreign prices are
multiplied by the value of the foreign currency in units of the domestic currency (E) in order to
express all prices in the same currency. Therefore, the real exchange rate is constant, though
not necessarily equal to 1.
b. The real exchange rate is constant, though not necessarily equal to 1.
c. The domestic price level (P) is equal to the foreign price level multiplied by the value of the
foreign currency in units of the domestic currency, in order to express all prices in the same
currency. Therefore, P = E × P*. This also implies that the real exchange rate is q = 1.
d. The domestic interest rate (R) is equal to the foreign interest rate (R*) plus the expected rate of
appreciation of the foreign currency.
4. Relative Purchasing Power Parity is the assumption that
a. The domestic price level (P) is equal to the foreign price level (P*) once foreign prices are
multiplied by the value of the foreign currency in units of the domestic currency (E) in order to
express all prices in the same currency. Therefore, P = E × P*. This also implies that the real
exchange rate is q = 1.
b. The real exchange rate is constant, though not necessarily equal to 1.
c. The domestic price level (P) is equal to the foreign price level (P*) once foreign prices are
multiplied by the value of the foreign currency in units of the domestic currency (E) in order to
express all prices in the same currency. Therefore, the real exchange rate is constant, though
not necessarily equal to 1.
d. The domestic interest rate (R) is equal to the foreign interest rate (R*) plus the expected rate of
appreciation of the foreign currency.
5. Suppose the annual inflation rates in the USA and in Japan are 2% and −1%, respectively. Then,
under purchasing power parity (absolute or relative), the dollars-per-yen exchange value of the yen
will
a.
b.
c.
d.
e.
remain roughly constant over time
decrease at the annual rate of 1%
increase at the annual rate of 1%
decrease at the annual rate of 3%
increase at the annual rate of 3%
6. Under purchasing power parity (absolute or relative),
a. The expected rate of appreciation of the foreign currency is equal to the excess of the foreign
inflation rate over the domestic inflation rate
b. If the foreign inflation rate is 7% and the domestic inflation rate is 5%, the foreign currency’s
value is expected to appreciate by 2%
c. If the foreign inflation rate is 7% and the domestic inflation rate is 5%, the foreign currency’s
value is expected to depreciate by 2%
d. If the foreign interest rate is 7% and the domestic interest rate is 5%, the foreign currency’s
value is expected to depreciate by 2%
7. Under fixed exchange rates, the expected rate of appreciation of the foreign currency is zero.
Therefore, assuming purchasing power parity (absolute or relative), it must be that
a.
b.
c.
d.
the foreign inflation rate equals the domestic inflation rate
the foreign inflation rate equals the domestic inflation rate plus the domestic interest rate
the foreign inflation rate is less than the domestic inflation rate
the foreign inflation rate is unrelated to the domestic inflation rate
8. In the long run, a country’s nominal interest rate (R) is affected by
a.
b.
c.
d.
Both the level and the rate of growth of the money supply that is generated by its central bank
The level but not the rate of growth of the money supply
The rate of growth but not the level of the money supply
Neither the level nor the rate of growth of the money supply
9. In the long run, a country’s nominal interest rate (R) depends
2
a.
b.
c.
d.
e.
Directly on the growth rate of its money supply
Inversely on the growth rate of its potential GNP
Directly on the foreign nominal interest rate (R*)
Inversely on the foreign inflation rate (π*)
All of the above
10. Suppose the annual inflation rates in the USA and in Japan are 2% and −1%, respectively. Also,
suppose the interest rate paid by Japanese banks is 3% per year. Then, under purchasing power
parity (absolute or relative) and interest parity (Ch. 14), the interest rate paid by American banks will
be
a.
b.
c.
d.
e.
0%
2%
3%
5%
6%
11. In the long run, a country’s output (that is, real GNP, Y)
a.
b.
c.
d.
e.
Fluctuates around its full-employment output (Yf)
Is usually higher than its full-employment output
Is usually lower than its full-employment output
Is usually equal to its full-employment output
Is largely unrelated to its full-employment output
12. In the long run, a country’s inflation rate (π)
a. Is equal to the rate at which the country’s money supply is being increased by its central bank
b. Is equal to the rate of increase of the money supply minus the rate of increase of the country’s
full-employment output
c. Is equal to the rate of increase of the money supply plus the rate of increase of the country’s
full-employment output
d. Is unrelated to the rate of increase of the money supply and the rate of increase of the country’s
full-employment output
e. Is equal to the domestic interest rate minus the foreign interest rate
13. Assuming other exogenous variables are unaffected, if a country’s central bank increases the rate at
which it increases the country’s money supply from 4% per year to 6% per year, which of the
following long-run changes will occur? (Assume the country has a system of freely floating exchange
rates.)
a.
b.
c.
d.
e.
The rate of inflation will rise by 2 percentage points
The exchange value of the country’s currency will fall by 2 percentage points
The rate of interest paid by the country’s banks will rise by 2 percentage points
Real GNP (Y) and the real exchange rate (q) will be unaffected
All of the above
3
14. In the long run, a country’s price level (P) will rise if
a.
b.
c.
d.
e.
The money supply increases
The growth rate of the money supply increases
Full-employment output decreases
The growth rate of full-employment output decreases
All of the above
15. According to the theory of an open economy with freely floating exchange rates that was discussed
in class, if the rate of inflation increases in a foreign country, how will the domestic economy be
affected in the long run?
a.
b.
c.
d.
e.
its own inflation rate will increase
its price level will increase
the exchange value of its currency will decrease
its real GNP and real exchange rate will both increase
none of the above will happen
16. The idea that in the long run a country’s inflation rate and interest rate tend to move together (in
the same direction and to the same extent) is called
a.
b.
c.
d.
The quantity theory of money
Absolute purchasing power parity
Uncovered interest parity
Fisher effect
17. According to theory discussed in class, in the long run, higher prices in the foreign country will be
accompanied by
a.
b.
c.
d.
e.
Higher value of the foreign country’s currency
Lower value of the foreign country’s currency
Higher prices in the domestic country
Higher output in the domestic country
Both (a) and (c) are correct
18. According to the section “Empirical Evidence on PPP and the Law of One Price” in your textbook,
which of the following is most accurate?
a.
b.
c.
d.
Both absolute and relative PPP do very well in explaining the facts
Both absolute and relative PPP do badly in explaining the facts
Absolute PPP does very well in explaining the facts but relative PPP does badly
Relative PPP does very well in explaining the facts but absolute PPP does badly
19. Which of the following is the most accurate statement about the section “Some Meaty Evidence on
the Law of One Price” in your textbook?
4
a. The Economist magazine collected data on Big Mac prices in various countries’ local currencies,
and converted the local-currency prices into dollar prices by multiplying the local-currency
prices by the dollar exchange rates of the local currencies.
b. According to the Law of One Price, the price of a Big Mac, when converted into dollars, will be
the same in all countries. Therefore, a comparison of the dollar prices of Big Macs all across the
world would be a way to test the Law of One Price.
c. According to The Economist’s investigation, the Law of One Price does not fit the data on Big
Mac prices very well
d. All of the above answers are correct
20. According to the section “Empirical Evidence on PPP and the Law of One Price” in your textbook,
which of the following is most accurate statement on the empirical testing of relative purchasing
power parity?
a. According to relative purchasing power parity theory, the real exchange rate (𝑞 = 𝐸 ∙ 𝑃∗ /𝑃)
would be constant in the long run, though not necessarily equal to 1. Suppose 𝑞 = 𝐸 ∙ 𝑃∗ /𝑃 =
3. Then, 𝐸 = 3𝑃/𝑃∗ . In that case, E and P/P* should always move in the same direction and
proportion.
b. Checking to see if the euro price of a dollar (E€/$) usually moves in the same direction and
proportion as PEurope/PUSA would be a good way to test RPPP.
c. When this kind of comparison was done for various countries, it was found that RPPP has not
done very well
d. All of the above answers are correct
5
ANSWER SHEET HOMEWORK 8 (Ch. 16) ECO41 FALL 2015 UDAYAN ROY
NAME: _______________________________________
DATE: ________________________________________
1
2
3
4
5
6
7
8
9
10
11
12
13
14
15
16
17
18
19
20
6