Chapter 15: Price Levels and the Exchange Rate in the Long Run Multiple Choice Questions 1.

In order for the condition E$/HK$ = Pus/PHK to hold, what assumptions does the principle of purchasing power parity ma e! ". #o transportation costs and restrictions on trade$ commodity %as ets that are a relia%le indication of price le&el. '. (ar ets are perfectly competiti&e, i.e., P = (). ). *he factors of production are identical %etween countries. +. #o ar%itrage e,ists. E. "ll of the a%o&e. "nswer- E .. /hich of the following statements is the most accurate! ". Predictions a%out long0run mo&ements in e,change rates are important e&en in the short run. '. Predictions a%out long0run mo&ements in e,change rates are not important the short run. ). Predictions a%out long0run mo&ements in e,change rates are important only in the long run. +. Predictions a%out long0run mo&ements in e,change rates are often not important in the short run. E. #one of the a%o&e. "nswer- " 1. /hich of the following statements is the most accurate! ". In the long run, national price le&els play a minor role in determining %oth interest rates and the relati&e prices at which countries2 products are traded. '. In the long run, national price le&els play a ey role only in determining interest rates. ). In the long run, national price le&els play a ey role only in determining the relati&e prices at which countries2 products are traded. +. In the long run, national price le&els play a ey role in determining %oth interest rates and the relati&e prices at which countries2 products are traded. E. #one of the a%o&e. "nswer- +

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/hich of the following statements is the most accurate! *he law of one price states". In competiti&e mar ets free of transportation costs and official %arriers to trade, identical goods sold in different countries must sell for the same price when their prices are e,pressed in terms of the same currency. '. In competiti&e mar ets free of transportation costs and official %arriers to trade, identical goods sold in the same country must sell for the same price when their prices are e,pressed in terms of the same currency. ). In competiti&e mar ets free of transportation costs and official %arrier to trade, identical goods sold in different countries must sell for the same price. +. Identical goods sold in different countries must sell for the same price when their prices are e,pressed in terms of the same currency. E. #one of the a%o&e. "nswer- "

5.

6nder Purchasing Power Parity, ". E$/E = P67 / PE. '. E$/E = PE / PE7. ). E$/E = P67 8 PE. +. E$/E = P67 0 PE. E. #one of the a%o&e. "nswer- "

9.

6nder Purchasing Power Parity, ". E$/E = Pi67/ PiE. '. E$/E = PiE / Pi67. ). E$/E = P67 / PE. +. E$/E = PE / PE7. E. #one of the a%o&e. "nswer- )

:.

/hich of the following statements is the most accurate! ". *he law of one price applies only to the general price le&el. '. *he law of one price applies to the general price le&el while PPP applies to indi&idual commodities. ). *he law of one price applies to indi&idual commodities while PPP applies to %oth the general price le&el and to indi&idual commodities. +. PPP applies only to indi&idual commodities. E. *he law of one price applies to indi&idual commodities while PPP applies to the general price le&el. "nswer- E

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/hich of the following statements is the most accurate! ". If PPP holds true, then the law of one price holds true for e&ery commodity as long as the reference %as ets used to rec on different countries2 price le&els are the same. '. If the law of one price holds true for e&ery commodity, PPP must hold automatically. ). If the law of one price holds true for e&ery commodity, PPP must automatically hold as long as the reference %as ets used to rec on different countries2 price le&els are the same. +. If the law of one price does not hold true for e&ery commodity, PPP cannot %e true as long as the reference %as ets used to rec on different countries2 price le&els are the same. E. #one of the a%o&e statements is true. "nswer- )

<.

/hich of the following statements is the most accurate! ". "%solute PPP does not imply relati&e PPP. '. =elati&e PPP implies a%solute PPP. ). *here is no causality relation %etween the two. +. "%solute PPP implies relati&e PPP. E. #one of the a%o&e statements is true. "nswer- +

13.

/hich of the following statements is the most accurate! ". =elati&e PPP is &alid e&en when a%solute PPP is not, pro&ided the factors causing de&iations from a%solute PPP are more or less sta%le o&er different commodities space. '. "%solute PPP is &alid e&en when relati&e PPP is not, pro&ided the factors causing de&iations from relati&e PPP are more or less sta%le o&er time. ). =elati&e PPP is &alid e&en when a%solute PPP is not, pro&ided the factors causing de&iations from a%solute PPP are more or less sta%le o&er time. +. =elati&e PPP is not &alid when a%solute PPP is not. E. #one of the a%o&e statements is true. "nswer- )

.1.

11.

/hich of the following statements is the most accurate! In general, ". *he monetary approach to the e,change rate is a long0run theory. '. *he monetary approach to the e,change rate is a short0run theory. ). *he monetary approach to the e,change rate is %oth a short0 and long0run theory. +. *he monetary approach to the e,change rate neither long0run nor short0run theory. E. #one of the a%o&e statements is true. "nswer- "

1..

*he monetary approach ma es the general prediction that ". *he e,change rate, which is the relati&e price of "merican and European money, is fully determined in the long run %y the relati&e supplies of those monies. '. *he e,change rate, which is the relati&e price of "merican and European money, is fully determined in the short run %y the relati&e supplies of those monies and the relati&e demands for them ). *he e,change rate, which is the relati&e price of "merican and European money, is fully determined in the short0 and long run %y the relati&e supplies of those monies and the relati&e demands for them +. *he e,change rate, which is the relati&e price of "merican and European money, is fully determined in the long run %y the relati&e supplies of those monies and the relati&e demands for them E. #one of the a%o&e statements is true. "nswer- "

11.

6nder the monetary approach to the e,change rate theory, money supply growth at a constant rate ". e&entually results in ongoing price le&el deflation at the same rate, %ut changes in this long0run deflation rate do not affect the full0employment output le&el or the long0run relati&e prices of goods and ser&ices. '. e&entually results in ongoing price le&el inflation at the same rate, %ut changes in this long0run inflation rate do affect the full0employment output le&el and the long0run relati&e prices of goods and ser&ices. ). e&entually results in ongoing price le&el inflation at the same rate, %ut changes in this long0run inflation rate do not affect the full0employment output le&el or the long0run relati&e prices of goods and ser&ices. +. e&entually results in ongoing price le&el inflation at the same rate, %ut changes in this long0run inflation rate do not affect the full0employment output le&el, only the long0run relati&e prices of goods and ser&ices. E. #one of the a%o&e statements is true. "nswer- )

.11

14. /hich of the following statements is the most accurate! In general, under the monetary approach to the e,change rate, ". the interest rate is not independent of the money supply growth rate in the short run. '. the interest rate is independent of the money supply growth rate in the long run. ). the interest rate is not independent of the money supply growth rate in the long run, %ut independent in the short run. +. the interest rate is not independent of the money supply growth rate in the long run. E. #one of the a%o&e statement is true. "nswer- + 15. /hich of the following statements is the most accurate! In general, under the monetary approach to the e,change rate, ". while the short 0run interest rate does not depend ion the a%solute level of the money supply, continuing growth in the money supply e&entually will affect the interest rate. '. while the long0run interest rate does depend on the a%solute level of the money supply, continuing growth in the money supply does not affect the interest rate. ). while the long0run interest rate does not depend on the a%solute level of the money supply, continuing growth in the money supply e&entually will affect the interest rate. +. the long0run interest rate does not depend on the a%solute level of the money supply, and thus continuing growth in the money supply will not affect the interest rate. E. #one of the a%o&e statements is true. "nswer- )

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If people e,pect relati&e PPP to hold, ". the difference %etween the interest rates offered %y dollar and euro deposits will e>ual the difference %etween the inflation rates e,pected, in the 6nited 7tates and Europe, o&er the rele&ant hori?on. '. the difference %etween the interest rates offered %y dollar and euro deposits will e>ual the difference %etween the inflation rates e,pected in Europe and the 6nited 7tates. ). the difference %etween the interest rates offered %y dollar and euro deposits will e>ual the difference %etween the inflation rates e,pected, o&er the rele&ant hori?on, in the 6nited 7tates and Europe, in the short run. +. the difference %etween the interest rates offered %y dollar and euro deposits will %e a%o&e the difference %etween the inflation rates e,pected, o&er the rele&ant hori?on, in the 6nited 7tates and Europe. E. #one of the a%o&e statements is true. "nswer- "

1:.

6nder PPP, ". a rise in a country2s e,pected inflation rate will e&entually cause a more0than proportional rise in the interest rate that depositors of its currency offer in order to accommodate for the higher inflation. '. a fall in a country2s e,pected inflation rate will e&entually cause an e>ual rise in the interest rate that depositors of its currency offer. ). a rise in a country2s e,pected inflation rate will e&entually cause an e>ual rise in the interest rate that depositors of its currency offer. +. a rise in a country2s e,pected inflation rate will e&entually cause a less than proportional rise in the interest rate that depositors of its currency offer to accommodate the rise in e,pected inflation. E. #one of the a%o&e statements is true. "nswer- )

1;.

In the short run, ". the interest rate can rise when the domestic money supply falls. '. the interest rate can decrease when the domestic money supply falls. ). the interest rate stays constant when the domestic money supply falls. +. the interest rate rises in the same proportion as the domestic money supply falls. E. #one of the a%o&e statements is true. "nswer- "

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6nder a fle,i%le0price monetary approach to the e,change rate, ". when the domestic money supply falls, the price le&el would e&entually fall, increasing the interest rate. '. when the domestic money supply falls, the price le&el would fall right away, causing a reduction in the interest rate. ). when the domestic money supply falls, the price le&el would fall right away, causing an increase in the interest rate. +. when the domestic money supply falls, the price le&el would e&entually fall, eeping the interest rate constant E. when the domestic money supply falls, the price le&el would fall right away, eeping the interest rate constant "nswer- E

.3.

6nder stic y prices, ". a fall in the money supply raises the interest rate to preser&e money mar et e>uili%rium. '. a fall in the money supply reduces the interest rate to preser&e money mar et e>uili%rium. ). a fall in the money supply eeps the interest rate intact to preser&e money mar et e>uili%rium. +. a fall in the money supply does not affect the interest rate in the short run, only in the long run. E. #one of the a%o&e statements is true. "nswer- "

.1.

6nder stic y prices, ". an interest rate rise is associated with lower e,pected deflation and a long0run currency appreciation, so the currency appreciates immediately. '. an interest rate rise is associated with higher e,pected inflation and a long0run currency appreciation, so the currency appreciates immediately. ). an interest rate rise is associated with lower e,pected inflation and a long0run currency depreciation, so the currency appreciates immediately. +. an interest rate rise is associated with lower e,pected inflation and a long0run currency depreciation, so the currency depreciates immediately. E. an interest rate rise is associated with lower e,pected inflation and a long0run currency appreciation, so the currency appreciates immediately. "nswer- E

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6nder the monetary approach to the e,change rate, ". an interest rate decrease is associated with higher e,pected inflation and a currency that will %e wea er on all future dates. '. an interest rate increase is associated with higher e,pected deflation and a currency that will %e wea er on all future dates. ). an interest rate increase is associated with higher e,pected inflation and a currency that will %e strengthened on all future dates. +. an interest rate increase is associated with higher e,pected deflation and a currency that will %e strengthened on all future dates. E. an interest rate increase is associated with higher e,pected inflation and a currency that will %e wea er on all future dates. "nswer- E

.1.

6nder the monetary approach to the e,change rate, ". a reduction in the money supply will cause immediate currency depreciation. '. a rise in the money supply will cause currency depreciation. ). a rise in the money supply will cause immediate currency appreciation. +. a rise in the money supply will cause depreciation. E. a rise in the money supply will cause immediate currency depreciation. "nswer- E

.4.

In practice, ". changes in national price le&els often tell us little or nothing a%out e,change rate mo&ements. '. changes in national price le&els raise the e,change rate. ). changes in national price le&els lower the e,change rate. +. changes in national price le&els often tell us a%out e,change rate mo&ements. E. #one of the a%o&e statements is true. "nswer- "

.1:

.5.

/hich of the following statements is the most accurate! ". *he prices of identical commodity %as ets, when con&erted to a single currency, are the same across countries. '. *he prices of identical commodity %as ets, when con&erted to a single currency, differ su%stantially across countries. ). *he prices of identical commodity %as ets, when con&erted to a single currency, do not differ su%stantially across countries. +. *he prices of identical commodity %as ets, when con&erted to a single currency, are often the same across countries. E. #one of the a%o&e statements is true. "nswer- '

.9.

/hich of the following statements is the most accurate! ". *he law of one price does fare well in all recent studies. '. *he law of one price does fare well in many recent studies. ). *he law of one price sometimes fares well in recent studies. +. *he law of one price does not fare well in recent studies. E. #one of the a%o&e statements is true. "nswer- +

.:.

/hich of the following statements is the most accurate! ". =elati&e PPP is not a reasona%le appro,imation to the data. '. =elati&e PPP is sometimes a reasona%le appro,imation to the data %ut usually performs poorly. ). =elati&e PPP is sometimes a reasona%le appro,imation to the data. +. PPP is sometimes a reasona%le appro,imation to the data. E. PPP is sometimes a reasona%le appro,imation to the data %ut usually performs poorly. "nswer- '

.;.

/hich of the following statements is the most accurate! ". PPP appears to %e of limited use as a short0run e,planation of e,change rate mo&ements. '. PPP appears to %e of limited use e&en as a short0run e,planation of e,change rate mo&ements. ). PPP appears to %e of limited use e&en as a long0run e,planation of e,change rate mo&ements. +. =elati&e PPP appears to %e of limited use e&en as a short0run e,planation of e,change rate mo&ements. E. #one of the a%o&e statements is true. "nswer- )

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/hich of the following statements is the most accurate! ". =elati&e PPP has not held up well since the 1<93s. '. =elati&e PPP has not held up well since the early 1<:3s, %ut in the 1<93s it was a more relia%le guide to the relationship among e,change rates and national price le&els. ). =elati&e PPP has held up well since the early 1<93s, %ut in the 1<:3s it was a more relia%le guide to the relationship among e,change rates and national price le&els. +. =elati&e PPP has held up well since the early 1<:3s. E. #one of the a%o&e statements is true. "nswer- '

13.

/hich of the following statements is the most accurate! ". *he price differences of 'ig (acs in "tlanta, )hicago, #ew @or . and 7an Arancisco are not larger than the international disparities. '. *he price differences of 'ig (acs in "tlanta, )hicago, #ew @or . and 7an Arancisco are close to ?ero. ). *he price differences of 'ig (acs in "tlanta, )hicago, #ew @or . and 7an Arancisco are less than 13 percent. +. *he price differences of 'ig (acs in "tlanta, )hicago, #ew @or . and 7an Arancisco are less than 15 percent. E. *he price differences of 'ig (acs in "tlanta, )hicago, #ew @or . and 7an Arancisco are in many cases larger than the international disparities. "nswer- E

11.

In "pril .331, the world2s cheapest 'ig (acs were sold in ". *he Philippines. '. =ussia. ). 6 raine. +. )hina. E. the )?ech =epu%lic. "nswer- "

1..

*he PPP theory fails in reality %ecause ". transport costs and restrictions on trade. '. monopolistic or oligopolistic practices in goods mar ets. ). the inflation data reported in different countries are %ased on different commodity %as ets. +. ", ', and ). E. " and ' only. "nswer- +

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/hich one of the following statements is the most accurate! ". *he purchasing power of any gi&en country will increase in countries where the prices of non0trada%le goods rise. '. *he purchasing power of any gi&en country will fall in countries where the prices of non0trada%le goods increase. ). *he purchasing power of any gi&en country will fall in countries where the prices of non0trada%le goods rise. +. *he purchasing power of any gi&en country will remain constant in countries where the prices of non0trada%le goods rise. E. *he purchasing power of any gi&en country will fall in countries where the prices of non0trada%le goods remain constant. "nswer- )

14.

/hich one of the following statements is the most accurate! 7ince 1<;1, ". Hong Kong2s price le&el has risen less rapidly than that of the 6nited 7tates despite a fi,ed e,change rate and no trade %arriers. '. Hong Kong2s price le&el has risen much more rapidly than that of the 6nited 7tates despite a fi,ed e,change rate and %ecause of no trade %arriers. ). Hong Kong2s price le&el has risen much more rapidly than that of the 6nited 7tates despite trade %arriers %ut %ecause of a fi,ed e,change rate regime. +. Hong Kong2s price le&el has risen much more rapidly than that of the 6nited 7tates despite a fi,ed e,change rate and no trade %arriers. E. Hong Kong2s price le&el has risen much less rapidly than that of the 6nited 7tates despite a fle,i%le e,change rate and no trade %arriers. "nswer- +

15.

/hich one of the following statements is the most accurate! In the early 1<<3s, ". %uyers in *o yo spent $5,333 more for a 6K0%uilt #issan than consumers in the 6K. '. %uyers in *o yo spent $5,333 less for a 6K0%uilt #issan than consumers in the 6K. ). %uyers in *o yo spent the same price for a 6K0%uilt #issan as consumers in the 6K. +. %uyers in *o yo spent more than $5,333 for a 6K0%uilt #issan than consumers in the 6K. E. #one of the a%o&e statements is true. "nswer- '

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/hich one of the following statements is the most accurate! ". =elati&e price changes could not lead to PPP &iolations e&en if trade were free and costless. '. =elati&e price changes could lead to PPP &iolations only if trade were free and costless. ). =elati&e price changes could lead to PPP &iolations e&en if trade were free and costless. +. Price changes could lead to PPP &iolations e&en if trade were free and costless. E. #one of the a%o&e statements is true. "nswer- )

1:.

/hich one of the following statements is the most accurate! ". +epartures from PPP are similar in %oth the short run and long run. '. +epartures from PPP are e&en greater in the long run than in the short run. ). +epartures from PPP are smaller in the long run than in the long run. +. It is hard to tell whether departures from PPP are greater in the short run than in the long run. E. +epartures from PPP are e&en greater in the short run than in the long run. "nswer- E

1;.

Aloating e,change rates ". systematically lead to larger and more fre>uent short0run de&iations from the relati&e PPP. '. systematically lead to much larger %ut less fre>uent short0run de&iations from the relati&e PPP. ). systematically lead to much larger and more fre>uent short0run de&iations from the relati&e PPP. +. systematically lead to much smaller and less fre>uent short0run de&iations from the relati&e PPP. E. systematically lead to much smaller %ut more fre>uent short0run de&iations from the relati&e PPP. "nswer- )

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Essay Questions 1. E,plain the Baw of Cne Price. Di&e an e,ample.

"nswer- *he law of one price states that in competiti&e mar ets free of transportation costs and trade %arriers, identical goods sold in different countries must sell for the same price when e,pressed in terms of the same currency. Pi67 = EE$/EF , EPiEF for good i. E$/E = Pi67/Pi6K If, for e,ample, the price of the same sweater was cheaper in Bondon than in #ew @or , 6.7. importers and 'ritish e,porters would ha&e an incenti&e to %uy sweaters in Bondon and ship them to #ew @or , pushing the Bondon price up and the #ew @or price down, until %oth were e>ual. .. E,plain Purchasing Power Parity.

"nswer- PPP states that the e,change rate %etween two countries2 currencies e>uals the ratio of the countries2 price le&els. " fall in a currency2s domestic purchasing power Ei.e. an increase in the domestic price le&elF will %e associated with a proportional currency depreciation in the foreign e,change mar et and &ice &ersa. E$/E = P67/PE where P is the price of a reference commodity %as et. =earrange- P67 = EE$/EF , EPEF *hus, PPP asserts that all countries2 price le&els are e>ual when measured in terms of the same currency. 1. +iscuss the relationship %etween PPP and the Baw of Cne Price.

"nswer- *he law of one price applies to indi&idual commodities while PPP applies to the general price le&el. Proponents of PPP argue that its &alidity in the long run doesn2t re>uire the law of one price to hold e,actly. /hen goods and ser&ices temporarily %ecome more e,pensi&e in one country than in others, the demands for its currency and its products fall, pushing the e,change rate and domestic prices %ac in line with PPP and &ice &ersa.

...

4.

+iscuss the differences %etween "%solute PPP and =elati&e PPP.

"nswer- "%solute PPP states that the e,change rate %etween two currencies e>uals the ratio of their price le&els. =elati&e PPP states that the percentage change in the e,change rate %etween two currencies o&er a gi&en period e>uals the difference %etween the inflation rates of those two currencies. 5. E,plain why =elati&e PPP is useful when comparing countries that %ase their price le&els on different product %as ets.

"nswer- Aor E,ample- If the 6.7. price le&el rises %y 13G o&er a year while Europe2s rises %y only 5G, relati&e PPP predicts a 5G depreciation of the dollar against the euro. *his Hust cancels the 5G %y which 6.7. inflation e,ceeds European, lea&ing the relati&e domestic and foreign purchasing powers of %oth currencies unchanged. EE$/E,t I E$/E,t01F/E $/E,t01 = J67,t I JE,t %etween dates t and t I 1. =elati&e PPP is useful when comparing countries that %ase their price le&els on different product %as ets. =elati&e PPP may %e &alid e&en when a%solute PPP is not. 9. E,plain why the e,change rate model %ased on PPP is a long0run theory.

"nswer- PPP theory is a monetary approach to the e,change rate. It is a long-run theory %ecause it does not allow for price rigidities. It assumes that prices can adHust right away to maintain full employment as well as PPP. :. Present and e,plain the Aundamental E>uation of the (onetary "pproach.

"nswer- "ssume E$/E = P67/PE and that domestic price le&els depend on domestic money demands and suppliesP67 = (767/BE=$, @67F PE = (7E/BE=E, @EF *herefore, the e,change rate is fully determined in the long run %y the relati&e supplies of those monies and the relati&e real demands for them. 7hifts in interest rates and output le&els affect the e,change rate only through their influence on money demand. ;. /hat are the predictions for the long run of the (onetary "pproach!

"nswerMoney supplies: Di&en the e>uations, E$/E = P67/PE P67 = (767/BE=$, @67F

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PE = (7E/BE=E, @EF one can show that an increase in the 6.7. money supply, (767, causes a proportional increase in the 6.7. price le&el, P67, which in turn causes a proportional increase in E$/K. *hus, an increase in 6.7. money supply causes a proportional long0run depreciation of the dollar against the euro and &ice &ersa. Interest rates: " rise in the interest rate =$ lowers 6.7. money demand BE=$, @67F there%y causing a rise in the 6.7. price le&el and a proportional depreciation of the dollar against the euro. Output levels: " rise in 6.7. output @67 raises real 6.7. money demand leading to a fall in the long0run 6.7. price le&el and an appreciation of the dollar against the euro. <. +iscuss the effects of ongoing inflation %ased on the PPP theory.

"nswer- Cther things e>ual, money supply growth at a constant rate e&entually results in ongoing price le&el inflation at the same rate as the money supply growth, %ut changes in this long0run inflation rate do not affect the full0employment output le&el or the long0run relati&e prices of goods and ser&ices. *he interest rate, howe&er, is affected %y continuing growth in the money supply EinflationF. *his can %e shown %y com%ining PPP with the interest parity condition Erefer to )h. 11F. *o show it analytically, recall that the condition of parity %etween dollar and euro assets isInterest rate in the 6nited 7tates is e>ual to interest rate in the euro countries plus e,pected depreciation of the dollar. "nd according to relati&e PPPEE$/Et I E$/E,t01F/E $/E,t01 = Inflation rate in the 6nited 7tates minus inflation rates in the euro countries. If people e,pect relati&e PPP to hold, the difference %etween interest rates offered %y dollar and euro deposits will e>ual the difference %etween the e,pected inflation rates, o&er the relati&e hori?on, in the 6.7. and Europe. 13. +escri%e and e,plain the relationship %etween e,pected inflation rates in two countries and their interest rate differential according to the PPP theory.

"nswer- E,pected inflation is gi&en %y the following e>uationJe= EPe I PF/P, where Pe is the e,pected price le&el in a country a year from today.

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If relati&e PPP is e,pected to hold, thenEEe$/E I E$EF/E $/E = J67,t I JE,t. )om%ine the e,pected &ersion of relati&e PPP with the interest parity condition=$ = =E8 EEe$/E I E$/EF/E$/E =earrange=$ I =E = J67,t I JE,t If, as PPP predicts, currency depreciation is e,pected to offset international inflation differences, the interest rate difference must e>ual the e,pected inflation difference. 11. /hat is the Aisher Effect! Pro&ide an e,ample.

"nswer- "ll else e>ual, a rise in a country2s e,pected inflation rate will e&entually cause an e>ual rise in the interest rate that deposits of its currency offer. 7imilarly, a fall in the e,pected inflation rate will e&entually cause a fall in the interest rate. E,- If the e,pected 6.7. inflation were to rise permanently from L to EL 8 MLF, current dollar interest rates =$ would e&entually catch up to the higher inflation, rising %y a &alue M=$ = ML in accordance with the (onetary "pproach that in the long run purely monetary de&elopments should ha&e no effect on an economy2s relati&e prices since the real rate of return on dollar assets would remain unchanged. 1.. *o answer the following >uestion, please refer to the figure %elow. )oncentrating only at the lower right >uadrant, discuss the effects of a change in 6.7. e,pected inflation.

"nswer- *he lower right >uadrant shows the e>uili%rium in the 6.7. (oney (ar et, where =1$ = (167/P167. " gi&en interest rate =1$ corresponds with a gi&en 6.7. real money supply, (167/P167 )onsider a rise of ML in the future rate of 6.7. money supply growth Ei.e. an increase in the e,pected rate of inflationF. *he Key Point- *he rise in e,pected future inflation generates e,pectations of more rapid currency depreciation in the future. 6nder PPP the dollar now depreciates at a rate of L 8 ML. Interest parity therefore re>uires the dollar interest rate to rise where

..5

=.$ = =1$ 8 ML. EPoint . in the figure.F #ote- =$ I =E= Le67 I LeE *his relation shows a change in the 6.7. interest rate due to an increase in e,pected 6.7. inflation has no effect on the euro interest rate. *he rise in the interest rate from =1$ to =.$ creates a momentary e,cess supply of real 6.7. money %alances at the pre&ailing price le&el P1. Howe&er, since under this Monetary pproach, prices are assumed to %e fle,i%le, prices will immediately adHust from P1 to P., thus causing the following two effects- Cne- =educing real money supply and, *wo- 'ringing the 6.7. money mar et %ac into e>uili%rium.

11.

*o answer the following >uestion, please refer to the figure %elow. )oncentrating only at the lower left >uadrant, discuss the relationship %etween

..9

11. *o answer the following >uestion, please refer to the figure %elow. )oncentrating only at the lower left >uadrant, discuss the relationship %etween the 6.7. real money supply and the dollar/euro e,change rate, E$/E. "nswer- *he lower left >uadrant in the figure descri%ed the Purchasing Power Parity EPPPF relationship. *he relationship %etween the 6.7. real money supply and the dollar/euro e,change rate, E$/E is negati&e. E$/E is e>ual to the price le&el ratio, P67/ PE. In this deri&ation of the relationship, the following &aria%les are assumed constants(167, =E, and PE. 7o, E$/E = (167/P67 *he increase in P67 leads to a positi&e increase in E$/E. P167 will shift to P.67 *hus, the purchasing power of the dollar decreases due to the increase in the price le&el. E1$/E will shift to E.$/E. *hat is, the dollar depreciates due to PPP.

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14.

*o answer the following >uestion, please refer to the figure %elow. )oncentrating only at the upper right >uadrant, discuss the foreign e,change mar et e>uili%rium.

"nswer- *he upper right >uadrant descri%es the e>uili%rium in the foreign e,change mar et. /e %egin with the Interest Parity )ondition=$ = =E8 EEe$/E 0 E$/EF / E$/E. In general, two effects are present=1$ mo&es to =.$ and E1$/E shifts to E.$/E. " rise in the interest rate normally creates an e,cess demand for dollar deposits and appreciation in the currency mar et. Howe&er, in this case the increase is due to higher e,pected inflation or higher e,pected monetary growth in the 6.7., which implies a faster expected depreciation of the dollar against the euro, E, thus, Ee$E goes up and therefore reduces the attracti&eness of 6.7. deposits.

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15.

Is a depreciation of the dollar/euro e,change rate correlated with a decrease in the dollar return on 6.7. deposits!

"nswer- #o. "ssume that the Interest Parity is maintained. Holding the foreign interest rate constant, one would e,pect a depreciation of the dollar/euro e,change rate Ei.e., an increase in EF to %e correlated with a decrease in the 6.7. interest rate, dollar returns on euro deposits. Howe&er, the higher e,pected inflation in the 6.7. implies an increase in the e,pected future dollar to euro e,change rate. *hus, e,pected depreciation increases despite a depreciation in the current dollar to euro e,change rate. 19. +oes the e,istence of non0trada%le goods allow for de&iations from Purchasing Power Parity!

"nswer- @es, the e,istence of non0trada%le goods allows de&iations from PPP. *his is %ecause the price of a non0trada%le good is determined entirely %y its domestic supply and demand cur&es, and in turn fluctuations in demand and supply for these goods will affect the price le&el. E,amples include housing, haircuts, ser&ices , etc. 1:. /hat effect do non0trada%le goods ha&e on PPP!

"nswer- *he effect is >uite su%stantial. In 1<<:, the output of non0trada%le goods accounted for a%out 55G of 6.7. D#P. "long with haircuts, non0trada%le goods include routine medical treatment, housing etc. Aor the most part, non0trada%le goods are comprised of ser&ices and the output of the construction industry. #on0trada%le helps e,plain much of the wide departure from PPP that is present in empirical data. 1;. /hat can e,plain the failure of relati&e PPP to hold in reality!

"nswerDo&ernment measures of the price le&el differ from country to country. Cne reason for these differences is that people li&ing in different countries spend their income in different ways. 'ecause of this inherent difference among countries, certain %as ets will %e affected more %y price changes gi&en their consumptions %as et. Aor e,ample, consumers in country N eat more fish relati&e to consumers in another country. (ore than li ely, the go&ernment, upon determining a commodity %as et to reflect preference, will ha&e an o&erwhelming representation of fish in their %as et. "ny price le&el change in the fish mar et will %e felt particularly %y country N, and their o&erall price le&el will reflect this. *hus, changes in the

..<

relati&e prices of %as et components can cause relati&e PPP to %ecome distorted.

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1<.

E,plain why price le&els are lower in poorer countries.

"nswer- Cne theory e,plains the difference in prices on different endowments of capital and la%or E'hagwait, Kra&is, and BipseyF. *he e,planation is as followsO=ich countries ha&e high capital0la%or ratios, while poor countries ha&e much more la%or relati&e to capital. O'ecause rich countries ha&e high capital0la%or ratios, the (PB is greater and thus they ha&e a higher wage. OHigher wages lead to higher disposa%le income, and citi?ens2 demand for goods will increase. O'ecause la%or is cheaper in poor countries and is used intensi&ely in producing non0 trada%le goods$ non0trada%le goods will %e cheaper in the poor countries than in the rich countries. O*he price of non0trada%le goods will mo&e with the increase in wages, thus increasing the price le&el of the goods. =ich )ountries- E,pensi&e #on0trada%le Doods &s. Poor )ountries- )heap #on0trada%le Doods. .3. /hat are the predictions of the PPP theory with regard to the real e,change rates!

"nswer- *he real e,change rate %etween two countries is a %road summary measure of the prices of one country2s goods and ser&ices relati&e to the other2s. PPP predicts that the real e,change rate ne&er permanently changes, which is different from nominal e,change rates that deal with the relati&e price of two currencies . .1. /hat is the real e,change rate %etween the dollar and the euro e>ual to!

"nswerBet, =eal dollar/euro e,change rate #ominal e,change rate Price of an unchanging %as et in 67 Price of an unchanging %as et in Europe *hen, >$/E E$/E P67 PE

>$/E = E$/E PE / P67. " rise in the real dollar/euro e,change rate is called a real depreciation of the dollar against the euro, a fall in purchasing power of the dollar. " fall in the real dollar/euro e,change rate is called a real appreciation of the dollar against

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the euro, a rise in purchasing power of the dollar.

.1.

...

How can long0run &alues in the real e,change rate change!

"nswer"n increase in world relati&e de!and for 6.7. output causes a long0run real appreciation of the dollar against the euro Ea fall in the real dollar/euro e,change rateF. " relati&e expansion of 6.7. output causes a long0run real depreciation of the dollar against the euro Ea rise in the real dollar/euro e,change rateF. .1. +escri%e the chain of e&ents leading to e,change rate determination for the following casesa. "n increase in the 6.7. money supply %. "n increase in the growth rate of the 6.7. money supply c. "n increase in world relati&e demand for 6.7. products d. "n increase in relati&e 6.7. output supply

"nswer- *he chain of e&ents leading to e,change rate determination*he spot e,change rate is e>ual to the real e,change rate times the ratio of 6.7. to European price le&els. Increase in "#$# !oney supply: *he price le&el in the 6.7. rises in proportion to the money supply$ the real e,change rate remains the same. "ll dollar prices will rise Eincluding the dollar price of the euroF. Increase in gro%th rate o& "#$# !oney supply: *he inflation rate, dollar interest rate, price le&el in the 6.7., and spot e,change rate rise in proportion to the increase in the price le&el in the 6.7. Increase in %orld relative de!and &or "#$# products: E falls, and ' does as well. Increase in relative "#$# output supply: *he dollar depreciates, lowering the relati&e price of 6.7. output. *he real e,change rate rises$ the effect on E is not clear since the real e,change rate and the price le&el in the 6.7. wor in opposite directions.

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.4.

)onstruct a ta%le that will summari?e the effects of money mar et and output mar et changes on the long0run nominal dollar/ euro e,change rate.

"nswer-

Increase in( 67 money supply European money supply

E&&ect Proportional Increase Proportional +ecrease Increase +ecrease +ecrease

growth rate European money supply growth rate

67 money supply +emand for 67 output +emand for European Cutput supply in 67 Cutput supply in Europe

output

Increase "m%iguous "m%iguous

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.5.

/hat is the real interest rate parity condition!

"nswer- *he nominal interest rates are rates of return measured in monetary terms. *he real interest rates are rates of return measured in real terms. =eal Interest Parity )ondition- Ere67 I reEF = E>e$/E I >$EF/ > $/E.

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Quantitative)*raphing Pro+le!s 1. 7uppose =ussia2s inflation rate is .33G o&er one year, %ut the inflation rate in 7wit?erland is only .G. "ccording to relati&e PPP, what should happen o&er the year to the 7wiss franc2s e,change rate against the =ussian ru%le!

"nswer- *he e,change rate %etween the ru%%le and the franc at time Et I *he same e,change rate at time t01F/ the e,change rate %etween the ru%%le and the franc at time t = . I 3.3. = 1.<;. 7o there will %e a 1<;G depreciation of the ru%le against the franc or, con&ersely, a 1<;G appreciation of the franc against the ru%le. .. "ssume that the dollar/pound e,change rate is $1.53 per pound. " sweater that sells for $45 in #ew @or must sell for how many pounds in Bondon!

"nswer- 13 pounds 1. Aill in the following ta%le, assuming the law of one price pre&ails. Price in the 6nited 7tates of a sweater e,pressed in dollars
20 30 40 50 60 70 80 90 100

Price in Europe e,pressed in euro

30 40 50 60 70 80 90 100 110

E,change rate %etween the dollar and the euro

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"nswerPrice in the "nited Price in Europe $tates o& a s%eater expressed in euro, expressed in dollars, Pi"$ PiE
20 30 40 50 60 70 80 90 100 30 40 50 60 70 80 90 100 110

Exchange rate +et%een the dollar and the euro, E-)E

0.666667 0.75 0.8 0.833333 0.857143 0.875 0.888889 0.9 0.909091

4.

Aill in the following ta%le, assuming the law of one price pre&ails.

Price in the "nited $tates o& a s%eater expressed in dollars, Pi"$

25 35 45 65

Price in Europe Exchange rate expressed in euro, +et%een the dollar PiE and the euro, E-)E
32 54 65 85 0.78125 0.833333333 0.846153846 0.82278481 0.882352941 0.787037037 0.871559633

85 95 115

139

"nswerPrice in the "nited $tates o& a s%eater expressed in dollars, Pi"$

25 35 45 55 65 75 85 95 115

Price in Europe Exchange rate expressed in euro, +et%een the dollar PiE and the euro, E-)E
32 42 54 65 79 85 108 109 139 0.78125 0.833333333 0.833333333 0.846153846 0.82278481 0.882352941 0.787037037 0.871559633 0.827338129

5.

"ssuming relati&e PPP, fill in the ta%le %elow-

.1:

E$/E,t

E$/E,t01
2 2.1 2.2 2.4 2.5 2.6 2.7 2.9 3

E$/E,t01
2 2.1 2.2 2.4 2.5 2.6 2.7 2.8 2.9

L67,t
2 2.1 2.2 2.4 2.5 2.6 2.7 2.8 2.9

LE,t
0.03 -0.08111 0.04 -0.01 0.002381 0.06 0.014545 0.07 0.026522 0.08 0.05 0.1 0.061538 0.11 0.072963 0.084286 0.13

"nswer- 6sing EE$/E,t I E$/E,t01F/E $/E,t01 = Inflation rate in the 6.7. minus inflation rate in Europe, one gets-

E$/E,t

E$/E,t01
2 2.1 2.2 2.3 2.4 2.5 2.6 2.7 2.8 2.9 3

E$/E,t01
1.8 2 2.1 2.2 2.3 2.4 2.5 2.6 2.7 2.8 2.9

L67,t
1.8 2 2.1 2.2 2.3 2.4 2.5 2.6 2.7 2.8 2.9

LE,t
0.03 0.04 0.05 0.06 0.07 0.08 0.09 0.1 0.11 0.12 0.13 -0.08111 -0.01 0.002381 0.014545 0.026522 0.038333 0.05 0.061538 0.072963 0.084286 0.095517

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