anshultongia

Which of the following statements regarding relative purchasing power parity is most accurate? Relative 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.

anshultongia

Willie Muller is a senior loan officer with a money center bank in New York. He has many multinational clients, including several who do a large percentage of their business with customers in Germany. Recent political developments in Europe have led to uncertainty regarding future exchange rates. The risk management team at Muller’s bank is concerned about the potential impact that increased volatility in exchange rates may have on his clients’ operations. The bank’s loans are denominated in U.S. dollars; however, these particular clients conduct their operations primarily in Euros. Since the clients bear the exchange rate risk, Muller and his risk management team are concerned about their clients’ exposure and the implications to the bank. Any negative impact to earnings could ultimately impair the ability of his clients to repay their outstanding loans. Muller has been asked to assess the bank’s exposure to Muller’s customers under a variety of economic scenarios.
In order to better understand his clients’ foreign exchange risk, Muller undertakes a review of the factors that underlie exchange rates including the principle of purchasing power parity (PPP). To do so, he must factor in the interrelationships between exchange rates, interest rates, and inflation rates. Also of importance are growth projections for the German economy, and how these might be affected by government policy. Muller begins to gather information that he believes may be useful in his analysis. He discovers that over the past two years, the price level in the U.S. has increased from 100 to 112 while the price level in Germany has increased from 100 to 104. Also, he notes that the current $/€ spot quote is 0.9808, while the one-year forward rate is 0.9906.
Muller recalls that changes in exchange rates between the U.S. and Germany should exactly offset the price effects of any inflation differential between the two countries. This version of PPP is called:

A) relative purchasing power parity.

B) absolute purchasing power parity.

C) the law of one price.

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Relative PPP depends on the ratio of the growth rates in prices (i.e. inflation) in the two countries. (Study Session 4, LOS 18.g)

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Which of the following is least likely a valid reason for the failure of absolute PPP?

A) differences in taxes, labor, and transportation costs between countries.

B) forward rates are unreliable and thin.

C) consumers do not have the same basket of goods and services.

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Forward rates, and the liquidity of the forward market will not have a bearing on the correctness of absolute PPP. The other items listed will cause actual exchange rates to deviate from what is predicted by absolute PPP. (Study Session 4, LOS 18.g)

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Muller observes that the $/€ spot exchange rate was 0.9857 two years ago. What does a comparison of the spot rate predicted by PPP with the current spot rate, i.e., 0.9808, tell us about changes in the relative cost advantage of U.S. exporters vs. German exporters? Since the spot rate predicted by the PPP relationship is:

A) $1.0615 per euro, U.S. exporters have a competitive disadvantage relative to German exporters.

B) $1.0615 per euro, U.S. exporters have a competitive advantage relative to German exporters.

C) $0.9153 per euro, U.S. exporters have a competitive disadvantage relative to German exporters.

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PPP indicates that the current spot rate should be 0.9857 (112 / 104) = 1.0615, compared with the actual spot rate of 0.9808. Hence, the U.S. dollar is stronger than it should be. This means that American goods have become more expensive relative to German goods, putting U.S. exporters at a relative disadvantage. (Study Session 4, LOS 18.h)

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Which of the following statements regarding the international Fisher relation is least accurate?

A) Real interest rates are not stable over time.

B) Countries with higher expected inflation will have higher nominal interest rates.

C) Real interest rates are equal across international boundaries.

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The international Fisher relation specifies that the interest rate differential between two countries should be equal to the expected inflation differential. That means countries with higher expected inflation will have higher nominal interest rates. The condition assumes that real interest rates are stable over time and equal across international boundaries. We could argue that this should be the case because differences in real interest rates between countries would encourage capital flows to take advantage of the differentials, ultimately equalizing real rates across countries. (Study Session 4, LOS 18.i)

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Muller is also interested in assessing the economic growth prospects for Germany. Suppose Germany's capital per labor hour grew by 1% while its real GDP per labor hour grew by 2%. Utilizing the one third rule, estimate the amount of real GDP per labor hour growth attributable to technological change.

A) 0.67%.

B) 0.33%.

C) 1.67%.

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Capital is responsible for 1/3 of the increase in real GDP so, 1/3 × 1% = 0.33%. The remaining 1.67% is attributed to technological change. (Study Session 4, LOS 14.b)

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Muller knows that government policies can have a significant impact on economic growth. Which of the following policies is least likely to foster a productivity speedup?

A) Pass laws that encourage higher rates of savings.

B) Foster technological advancement.

C) Restrict international trade.

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Technological advancement and higher rates of savings are important factors that tend to promote economic growth. (Study Session 4, LOS 14.b)

anshultongia

Carole Holden, CFA, is an economist for the International Monetary Fund. As a believer of purchasing power parity (PPP), she wants to create a suitable basket of goods for use in all countries as a means of determining exchange rates. Although she is very idealistic in her endeavor, one major shortcoming in her approach is that absolute PPP assumes:

A) real interest rates are constant throughout the world.

B) there are no restraints to trade.

C) inflation rates are constant throughout the world.

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Absolute PPP is of little use in determining exchange rates. In order to directly compare the prices of goods and services between two countries, identical individual goods and services are necessary to establish the validity of the law of one price. However, goods are rarely identical between various countries. In reality, restraints to trade, including differences in taxes, transportation and labor costs, rents, and government controls (e.g., tariffs) provide complexities that prevent direct comparison. Therefore, it is difficult (if not impossible) to confirm whether exchange rates are under- or overvalued according to absolute PPP.

anshultongia

Harold Jennings, CFA, an economist the World Bank, is considering the use of purchasing power parity (PPP) as a useful tool in forecasting exchange rates for certain South American countries. The appropriate method he should use is:

A) relative PPP because it tends to hold over the short run.

B) relative PPP because it tends to hold over the long run.

C) absolute PPP because it tends to hold over the long run.

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Although evidence tends to suggest that PPP does not hold in the short run, empirical evidence suggests that relative PPP does tend to hold more closely over the longer term. Currencies that become overvalued or undervalued in relation to PPP over time tend to eventually revert back to the long-term level predicted by relative PPP. That means relative PPP is somewhat useful in exchange rate determination in the short run because currencies that are overvalued relative to their PPP-determined fundamental value will tend to depreciate, while undervalued currencies will tend to appreciate. However, the adjustment period can sometimes be quite long (i.e., several years). Note that absolute PPP is of little use In determining exchange rates because we would need to have identical individual goods and services to establish validity, and goods consumed are rarely identical between various countries.

anshultongia

Suppose the United States and Europe produce only one good, chocolate. The price of chocolate is $8.25/kg in the United States and €13.60/kg in Europe. According to the law of one price, the $ to € spot exchange rate should be closest to:

A) $0.607.

B) $1.607.

C) $1.648.

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Since the price of chocolate must be the same in both economies, the spot exchange rate should be:

anshultongia

Suppose the United States and Europe produce only one good, chocolate. The price of chocolate is $8.25/kg in the United States and €13.60/kg in Europe. According to the law of one price, the $ to € spot exchange rate should be closest to:

A) $0.607.

B) $1.607.

C) $1.648.

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Since the price of chocolate must be the same in both economies, the spot exchange rate should be:

anshultongia

With respect to the relative purchasing power parity (PPP) equation, compounded inflation rates are applicable when:

A) real interest rates are expected to hold for multiple periods over a certain stated time horizon.

B) inflation rates are expected to hold for multiple periods over a certain stated time horizon.

C) expected exchange rates are expected to hold for multiple periods over a certain stated time horizon.

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Relative PPP holds that exchange rate movements reflect differences in inflation rates between countries. The relative version depends on the growth rates of prices in two countries. It is the rate of inflation that is critical here.
It is necessary to make a slight adjustment to the relative PPP equation to account for the compounded inflation rate over the time horizon if the problem involves multiple periods:

St / S0 = (1 + iFC)t / (1 + iDC)t

anshultongia

Which of the following purchasing power concepts depends on the growth rate of prices in two countries?

A) Absolute PPP.

B) International Fisher relation.

C) Relative purchasing power parity (PPP).

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Relative PPP holds that exchange rate movements reflect differences in inflation rates between countries. The relative version depends on the growth rates of prices in two countries.

anshultongia

The law of one price applies with respect to:

A) both absolute and relative PPP.

B) absolute purchasing power parity (PPP), but does not apply to relative PPP.

C) relative PPP, but does not apply to absolute PPP.

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The law of one price focuses on a single, clearly comparable good and states that the same good should have the same real prices in all countries. Absolute PPP is an average version of the law of one price. Rather than focusing on a single good, absolute PPP focuses on a weighted average price level of a representative basket of goods and services. Relative PPP holds that exchange rate movements reflect differences in inflation rates between countries. The relative version depends on the growth rates of prices in two countries. It is the rate of inflation (i.e., the relative rate of change in prices) that is critical here.

anshultongia

Which of the following statements regarding purchasing power parity (PPP) is least accurate?

A) Under absolute PPP the foreign price level expressed in domestic currency terms should be equal to the domestic country’s price level.

B) Absolute PPP is similar to the law of one price, except it concerns a basket of goods rather than a single good.

C) Relative PPP states that prices for goods and services are the same whether it is for one good or for a basket of goods.

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Relative PPP does not state that prices for goods and services are the same, only that the rate of change in the FX rate is a function of the inflation differentials between the two countries.