Exam I with answers

Econ 457, Exam 1, February 11, 2016
All multiple choice questions are worth 4 points each.
1. Which one of the following statements is the most accurate?
A) It is hard to tell whether departures from PPP are greater in the short run than in the long run.
B) Departures from PPP may often be greater in the short run than in the long run.
C) Departures from PPP are similar in both the short run and long run.
D) Departures from PPP are even greater in the long run than in the short run.
2. Which of the following statements is the most accurate?
A) Relative PPP implies absolute PPP.
B) There is no causality relation between the two.
C) Absolute PPP implies relative PPP.
D) Absolute PPP does not imply relative PPP.
3. Bonus question: The Economist’s analysis “Dollar in the global monetary system” highlights
A. over time euro and yuan are replacing dollars as the world’s dominant currency
B. dollar transactions constitute more than 50% of world’s trade and GDP.
C. A widespread use of dollars as a reserve currency has made Fed’s interest rate
policies affect other countries.
D. Both B and C above.
4. When a country's currency depreciates,
A) foreigners find that its exports are more expensive, and domestic residents find that
imports from abroad are more expensive.
B) foreigners find that its exports are more expensive, and domestic residents find that
imports from abroad are cheaper.
C) foreigners find that its exports are cheaper; however, domestic imports are not affected.
D) None of the above.
5. Forward and spot exchange
A) are necessarily equal.
B) do not move closely together.
C) are always such that the forward exchange rate is higher.
D) do move closely together, but are not necessarily equal.
6. Apple needs to pay 5000 yuans per iPhone to its Chinese suppliers in a month. The following is an
example of Apple hedging its foreign currency risk.
A) Apple makes a forward- exchange deal to buy yuans.
B) Apple makes a forward-exchange deal to sell yuans.
C) Apple buys yuans at a spot-exchange 1 month from now
D) Apple sells yuans at a spot-exchange 1 month from now
7. Which major actor is at the center of the foreign exchange market?
A) corporations
B) central banks
C) commercial banks
D) non-bank financial institutions
8. If the dollar interest rate is 3 percent and the euro interest rate is 6 percent, then you should
A) invest only in dollars.
B) invest only in euros.
C) be indifferent between dollars and euros.
D) It is impossible to decide between the two, given the information.
9. The PPP theory fails in reality because
A) not all goods are traded across countries
B) transport costs and restrictions on trade.
C) monopolistic or oligopolistic practices in goods markets.
D) all of the above.
10. Suppose 40% of Home country’s trade is with Country 1 and 60% is with Country 2. If Home’s
currency appreciates 10% against Country 1’s but depreciates 40% against Country 2’s, Home’s effective
exchange rate has
A. depreciated by 6%.
B. appreciated by 14%.
C. depreciated by 20%.
D. depreciated by 14%
11. A U.S. firm expects to receive payment of €1 million in 90 days for exports to France. At an
exchange rate of 1.1$/€, the firm will make zero profits. If the exchange rate in 90 days turns out to
be 1$/€, assuming zero transaction costs, the firm will make
A. a profit of $100,000.
B. a profit of $10,000.
C. a loss of $100,000.
D. a loss of $10,000
12. If euros can be obtained at € 0.9/$, and pounds can be obtained at £ 0.7/€, the cross rate between the
pound and the dollar must be
A. £ 1.52/$.
B. £ 0.85/$.
C. £ 1.15/$.
D. £ 0.63/$.
13. For two countries (Home and Foreign), the uncovered interest parity condition implies that the Home
interest rate must equal
A. the Foreign interest rate.
B. the Foreign interest rate plus the expected rate of depreciation of the Home currency.
C. the Foreign interest rate plus the expected rate of depreciation of the foreign currency.
D. Foreign interest rate less foreign inflation rate
14. Let PUS be the price of a basket of goods in the United States, PEUR the price of the same basket in Europe, E
the nominal exchange rate in terms of $ per €, and qEUR/US the real exchange rate indicating the number of U.S.
baskets needed to buy 1 European basket. The U.S. will experience a real depreciation if, ceteris paribus,
A. PEUR falls.
B. E falls.
C. PUS rises.
D. None of the above
15. The Quantity Theory of Money states that the demand for money is given by Md = L x P x Y, where P is the
price level, Y is real income and L is a constant. If the price level rises by 10% and real income is fixed, the
demand for money will
A. rise by more than 10%.
B. rise by less than 10%.
C. rise by 10%.
D. fall by 10%
16. The demand for money is given by Md = P x Y x L(i), where P is the price level, Y is real income and i is the
nominal interest rate. The demand function implies that a fall in the nominal interest rate, ceteris paribus, will
cause the money demand to
A. increase.
B. decrease.
C. remain unchanged.
D. None of the above
17. Suppose expected inflation is 4% in the United Kingdom and 7% in the United States. If relative PPP
holds, the market would expect the pound to
A. depreciate by 3% against the dollar.
B. depreciate by 8% against the dollar.
C. appreciate by 3% against the dollar.
D. appreciate by 5% against the dollar.
18. Suppose expected inflation is 4% in the United States and 3% in France. If interest rates in France are
4%, according to the Fisher Effect, the interest rate in the U.S. must equal
A. 1%. B. 5%. C. 6%. D. 2%
19. Bonus Question (4 points): The Economist article “Hope the Niara falls” argues that Nigeria
(a) Impose further import restriction to continue its fixed exchange rates
(b) Impose capital controls on capital outflows
(c) Impose capital controls on capital inflows
(d) Let the currency depreciate
20. Suppose that the one-year forward price of euros in terms of dollars is equal to $1.113 per euro.
Further, assume that the spot exchange rate is $1.05 per euro, and the interest rate on dollar deposits is 10
percent and on euro it is 4 percent. Show that the Covered Interest Parity condition holds in this case. [7
One has to plug in the numbers to check whether
Dollar interest rate = (1/spot rate)* Euro interest rate * Forward rate
holds or not. It does indeed.
21. Dollar euro exchange rate is 1.35$/euro. Dollar yen exchange rate is 0.0125 $/yen. What
would be the euro-yen exchange rate for no-arbitrage to hold? [6 points]
0.0125/1.35 euro/yen
22. A basket of consumption commodities in Canada cost C$100 in 1970 in Canada, whereas by
1990 the same had gone to C$392. In the US, the price of an identical basket rose from $100 to
$336. In 1970 the dollar/looney exchange rate was 1, whereas by 1990 the exchange rate was
1.16 C$ per US$. What would it cost a Canadian to buy the US consumption basket in 1990?
What would it cost in US $ to buy Canadian basket? (7 points)
For a Canadian the cost of a 1990 US basket is 1.16*336 = 389.8 C$
For a US resident the cost of a 1990 Canadian basket is 392/1.16 = 337.9 $
23. A big Mac costs 10 yuans in China, while it costs $4 in the US. The yuan/$ exchange rate is
7. Is yuan undervalued or overvalued relative to its value predicted by the law of one price for
big Macs? By what percentage? (6 points)
LOOP will require yuan/$ exchange rate to be 10/4 = 2.5 yuans. But it is 7 yuan – it is too
cheap in the market – i.e., undervalued. The undervaluation is by (7-2.5)/2.5 = 4.5/2.5 = 1.8.
One would say that it is undervalued by 180%. The yuan will have to depreciate by 180%
to reach its value predicted by LOOP.
24. Suppose EU prices and outputs remain constant. US output is constant but the Fed announces
that US money supply will now onwards grow at 10%, while previously it was kept constant.
Assuming PPP holds, what is the implication for $-euro exchange rate? Assume that the money
demand does not depend on the nominal interest rates. That is the real money demand is given by
the quantity theory of money. (6 points)
The dollar/euro exchange rate is the ratio of P_US and P_EU by PPP. Nothing happens to
P_EU – it is clear. If money supply begins growing by 10%, prices begin growing by 10%
too by the quantity theory equation which says that M/P = L Y. Since the RHS is constant
for the LHS to be constant P_US grows by 10% too. Then the exchange rate grows by 10%
too. However, there is no change at the time when the policy is announced, because the
Money supply does not change at that moment.