Reading 17: The Exchange Rate and the Balance of Payments-LOS regarding, 2011, following, class, statements

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Session 4: Economics for Valuation
Reading 17: The Exchange Rate and the Balance of Payments

LOS d: Differentiate between interest rate parity and purchasing power parity.

 

 

Which of the following statements regarding purchasing power parity is most accurate? Purchasing power states that exchange rates:

A) will change to reflect differences in inflation between countries.

B) will change to reflect differences in real interest rates between countries.

C) will change to reflect differences in nominal interest rates between countries.

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Purchasing power parity states that exchange rates will change to reflect differences in inflation between countries. Interest rate parity states that exchange rates must change so that risk-adjusted returns on investments in any currency will be equal.

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Terrance Burnhart, a junior analyst at Wertheim Investments Inc., was discussing the concepts of purchasing power parity (PPP) and interest rate parity (IRP) with his colleague, Francis Ferngood. During the conversation Burnhart made the following statements:

Statement 1: PPP is based on a number of unrealistic assumptions that limits its real-world usefulness. These assumptions are: that all goods and services can be transported among countries at no cost; all countries use the same basket of goods and services to measure their price levels; and all countries measure their rates of inflation the same way.

Statement 2: IRP rests on the idea of equal real interest rates across international borders. Real interest rate differentials would result in capital flows to the higher real interest rate country, equalizing the rates over time. Another way to say this is that differences in interest rates are equal to differences in expected changes in exchange rates.

With respect to these statements:

A) both are correct.

B) only statement 1 is correct.

C) only statement 2 is correct.

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IRP means that interest rates and exchange rates will adjust so the risk adjusted return on assets between any two countries and their associated currencies will be the same. PPP is based on the idea that a given basket of goods should cost the same in different countries after taking into account the changes in exchange rates. PPP does not hold due to transportation costs and other factors.

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Professor Imada Suzaken made the following statement to his economics class: “If you can earn 8% on A-rated bonds in the U.S. but only 6% on similar bonds in Canada, Canadian investors may want to buy those bonds in the U.S. for the excess return. However, after collecting the extra dollars, the investors would lose those profits when they converted their gains into their home currency.”

Suzaken is describing:

A) interest-rate parity.

B) exchange-rate parity.

C) purchasing-power parity.

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Interest-rate parity is the concept that exchange rates must change so that the return on investments with identical risk will be the same in any currency. Suzaken’s statement reflects interest rate parity.

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According to the concept of purchasing power parity, when the relationship between prices in two countries changes, those changes should be reflected in the:

A) interest rates.

B) exchange rate.

C) relative inflation rate.

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Purchasing power parity implies that changes in the price levels in two countries should be reflected in changes in the exchange rate.