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:

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
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 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:

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:

5)

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We can expect deviations from PPP because of
A)

quotas and tariffs.

B)

transportation costs.
C)

differentiated goods.
D)

All of the above.

Answer:

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:

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 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:

8)

PPP holds better for ________ countries.

A)

low-inflation
B)

poor
C)

rich
D)

high-inflation
Answer:

9)

We expect PPP to hold better

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 A)

for annual data than monthly data.

B)

for high-inflation countries.

C)

in the long run.

D)

All of the above.

Answer:

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:

11)

If American and Japanese consumers buy the same basket of goods in each country and there is no
inflation in either country,
A)

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the law of one price will hold.
B)

deviations from PPP will occur.

C)

PPP will hold.

D)

Both A and C.
Answer:

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:

13)

Evidence suggests that, following some exogenous shock, exchange rates change
A)

before prices change.

B)

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after prices change.
C)

at the same time prices change.

D)

None of the above.

Answer:

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:

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)

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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:

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:

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.

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 D)

None of the above.

Answer:

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:

19)

If absolute PPP held, then the real exchange rate must be equal to
A)

a constant.
B)

one.
C)

zero.
D)

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a positive number.
Answer:

10
 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:

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:

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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:

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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

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 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:

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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)

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 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

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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 long-run 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..

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