Chapter 8
Relationships Between Inflation, Interest Rates, and Exchange Rates
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1. There are various forms of purchasing power parity (PPP) theory. Which form of PPP is also known as the "law of one price"?
a. numerical form
b. relative form
c. accounting form
d. absolute form
e. none of the above

2. Inflation in the U.S. is 3% and the inflation rate in Europe is 5%. From the perspective of the U.S., what should the euro adjustment be if purchasing power parity (PPP) applies?
a. 1.94% appreciation
b. -1.9% depreciation
c. -1.94% depreciation
d. 1.9% appreciation
e. none of the above

3. Which of the following is not a reason for deviations in PPP?
a. relative income levels
b. trade barriers
c. interest rate differentials
d. several substitutes for traded goods
e. all of the above are reasons for deviations

4. Assume Switzerland has a one-year interest rate of 3% and the U.S. has a 4%, one-year interest rate. If the International Fisher effect (IFE) holds, what would your forecast for the Swiss franc exchange rate with respect to the dollar be?
a. 9.7% appreciation
b. 9.7% depreciation
c. 0.97% appreciation
d. 0.97% depreciation
e. none of the above

5. Assume the United Kingdom has a one-year interest rate of 6% and the U.S. has a 4%, one-year interest rate. If the spot rate is $1.50 per British pound and the international Fisher effect (IFE) holds, what would you forecast for the future spot rate of the pound in one year (using the simplified method)?
a. $1.5288
b. $1.5300
c. $1.4700
d. $1.4717
e. none of the above

6. Which of the following statements is false?
a. the international Fisher effect (IFE) uses interest rates to predict forward rates.
b. the international Fisher effect (IFE) uses interest rates to predict future spot rates.
c. interest rate parity (IRP) uses interest rates to predict forward rates.
d. purchasing power parity (PPP) uses inflation rates to predict future spot rates.
e. all of the above are true statements.

7. The absolute form of purchasing power parity (PPP) accounts for the possibilities of market imperfections such as transportation costs, tariffs, and quotas.
a. True
b. False

8. While the relationship between inflation differentials and exchange rates is not perfect even in the long run, recent research supports the use of inflation differentials to forecast long-run movements in exchange rates.
a. True
b. False

9. The International Fisher effect (IFE) uses interest rates rather than inflation rate differentials to explain exchange rate changes over time. It is closely related to the PPP theory because interest rates are often not correlated with inflation rates.
a. True
b. False

10. It is possible for purchasing power parity (PPP) to hold but for the international Fisher effect (IFE) to not hold over the same time period.
a. True
b. False

11. Unlike purchasing power parity (PPP), the international Fisher effect (IFE) consistently holds over the short run.
a. True
b. False

12. The international Fisher effect (IFE) and interest rate parity (IRP) use interest rate differentials to predict expected future spot rates.
a. True
b. False

13. A somewhat simplified statistical test of purchasing power parity (PPP) could be developed by applying regression analysis to historical exchange rates and inflation differentials.
a. True
b. False


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