# Inflation and Power Parity Level

Topics: Inflation, United States dollar, Spot price Pages: 15 (2730 words) Published: May 9, 2012
CHAPTER 4
Parity Conditions in International Finance and Currency Forecasting

EASY (definitional)

4.1 In its absolute version, purchasing power parity states that price levels worldwide should be _______when expressed in a common currency. a) equal
b) roughly equal
c) different
d) opportunities for arbitrage

Ans:a

Level: Easy

4.2 The theory of relative purchasing power parity states that, between two nations, the a) inflation rates are unrelated
b) exchange rate differential reflects the inflation rate differential c) inflation rate is smaller in weaker currencies
d) the interest rate is greater than the inflation rate during depreciations

Ans:b

Level: Easy

4.3 The Fisher effect states that the _________ rate is made up of a real required rate of return and an inflation premium. a) nominal exchange
b) real exchange
c) nominal interest

Ans:c
Section: The fisher effect
Level: Easy

4.4 A rise in the inflation rate in one nation relative to others will be associated with a fall in the first nation’s exchange rate and with a rise of its interest rate relative to foreign interest rates. The two conditions combined result in the _________ Effect. a) Fisher

b) Herstatt
c) Unbiased forward rate
d) International Fisher

Ans:d

Section: The fisher effect
Level: Easy

MEDIUM (applied)

4.5 Suppose annual inflation rates in the U.S. and Mexico are expected to be 6% and 80%, respectively, over the next several years. If the current spot rate for the Mexican peso is \$.005, then the best estimate of the peso's spot value in 3 years is a) \$.00276

b) \$.01190
c) \$.00321
d) \$.00102

Ans:d
Level: Medium

4.6 If the expected inflation rate is 5% and the real required return is 6%, then the Fisher effect says that the nominal interest rate should be a) 1%
b) 11.3%
c) 11%
d) 6%

Ans:b
Section: The fisher effect
Level: Medium

4.7 The inflation rates in the U.S. and France in January 1991 were expected to be 4% per annum and 7% per annum, respectively. If the current spot rate that day was \$.1050, then the expected spot rate in three years was a) \$.1150

b) \$.1112
c) \$.0964
d) \$.0992

Ans:c
Level: Medium

4.8 Suppose the expected inflation in the U.S. on January 1, 1988 was projected at 5% annually for the next 5 years and at 12% annually in Italy for the same time period, and the lira/\$ spot rate that day was currently at L2400 = \$1, then the PPP estimate of the spot rate five years from now was a) 1738

b) 3314
c) 2560
d) 2250

Ans:b
Level: Medium

4.9 If expected inflation is 20% and the real required return is 10%, then the Fisher effect says that the nominal interest rate should be exactly a) 30%
b) 32%
c) 22%
d) 12%

Ans:b
Section: The fisher effect
Level: Medium

4.10 On January 1, 1990, the annual inflation rates in the U.S. and Greece were expected to be 3% and 8%, respectively. If the current spot rate that day for the drachma was \$.007, then the expected spot rate in three years was a) \$.00607

b) \$.00823
c) \$.00751
d) \$.00694

Ans:a
Level: Medium

4.11 If a country's freely floating currency is undervalued in terms of purchasing power parity, its capital account is likely to be a) in deficit or tending toward a deficit
b) in surplus or tending toward a surplus
c) Subsidized by the International Monetary Fund
d) a candidate for loans from the World Bank

Ans:a
Level: Medium

4.12 If the rate of inflation in all of the world’s currency markets rises from 5% to 7%, this will tend to make forward exchange rates move toward a) Smaller premiums or larger discounts in...