1.Purchasing power parity implies that a. the real exchange rate is equal to 1.

Question

1.Purchasing power parity implies that

a. the real exchange rate is equal to 1.               

b. the law of one price does not hold.

c. inflation rates are equal across countries.

d. the real exchange rate is equal to 0.

e. if the domestic country has low prices, then the domestic currency will depreciate until foreign citizens can buy the same amount of goods as domestic citizens.

2.Which of the following is a prediction from the PPP model of exchange rates?

A. An increase in the US money supply leads to an appreciation of the dollar in the long run.

B. An increase in US production leads to a depreciation of the dollar.

C. An increase in US production will lead to a proportional increase in inflation rate.

D, An increase in the US money supply leads to a depreciation of the dollar in the long run.

E.An increase in the US interest rates leads to a fall in prices.

3.Relative purchasing power parity predicts that

A.the difference between the inflation rates in two countries should equal the ratio of the interest rates in the two countries.

B. the difference between the inflation rates in two countries should equal the percent change in the exchange rate.

C.inflation rates should be equal across countries.

D.the real exchange rate should equal one.

E.relative price levels in two countries should be equal when expressed in the same currency.

4.Which of the following is NOT a valid explanation for the failure of purchasing power parity?

a. Differences in monetary policies across countries

b. Lack of competition

c. Transportation costs

d. Trade barriers

5.If P represents (the level of) domestic prices, P* represents (the level of) foreign prices and E represents the exchange rate as units of domestic currency per units of foreign currency, then the real exchange rate equals

a. EP/P*

b. P*/EP

C. E/PP*

d. EP*/P

e. P/P*

6.The difference between nominal and real interest rates is that

A.Nominal interest rates are measured in terms of a country’s output, while real interest rates are measured in monetary terms

B.Nominal interest rates are measured in monetary terms, while real interest rates are measured in terms of a country’s output

C.Nominal interest rates can fluctuate, while real interest rates always remain fixed

D.Real interest rates can fluctuate, while nominal interest rates always remain fixed

E.Real interest rates are the same in every country, while nominal interest rates are different for every country

7.Which of the following is predicted to cause the value (or price or cost) of U.S. goods to appreciate relative to the value (or price or cost) of foreign goods in the long run?

a. An increase in the growth rate of U.S. GNP. b. A decrease in the growth rate of U.S. GNP.

c. A decline in the growth rate of the U.S. money supply.

d. An increase in the price of petroleum that reduces world demand of American cars. e. An appreciation of the dollar.

a. EP/P*

b. P*/EP

C. E/PP*

d. EP*/P

e. P/P*

Explanation / Answer

1. If the purchasing power parity holds exactly the real exchange rate would always be equal to 1.  Though in real circumstances this value remains deviated from this value. But if PPP exactly holds the real exchange will always be equal to ONE.

So the correct option is (a) the real exchange rate is equal to 1

2. A temporary increase in the real money supply at home in the short run will lead to a fall in the value or depriciation of the currency of home country against the foreign currency.

This implies that the correct option for this question is (d)

3.

Relative purchasing power parity predicts that the difference between the inflation rates in two countries should equal the ratio of the interest rates in the two countries.

Relative purchasing power (RPP) parity refers to the expected inflation rate changes of the two countries with respect to their exchange rate changes. Real purchasing power of a nation gets reduced by the inflation. For instance if the inflation rate at the end of the year of a country is 5%, that country’s purchasing capacity gets reduced by 5% at the end of that year. RPP shows that rates of exchange will change in order to compensate for the difference in inflation rate of the two countries and it also checks the relative changes in the price levels between the two concerned countries

So the correct answer is (a)

4. Differences in monetary policies across countries s NOT a valid explanation for the failure of purchasing power parity

PPP assumptions, include:

Violation of any of the above assumptions would lead to failure of PPP. So differences in monetary policies across countries will not cause the failure of PPP. So the correct option is (a)

5. The real exchange rate (RER) between the two concerned currencies is the multiplication of the nominal rate of exchange and the price ratio between the two said countries. The equation is RER = eP*/P

So the correct option is (d).

6. Nominal interest rates are measured in monetary terms, while real interest rates are measured in terms of a country’s output. The correct option is therefore (b).

7. An appreciation of the dollar cause the value (or price or cost) of U.S. goods to appreciate relative to the value (or price or cost) of foreign goods in the long run

so the correct option is (e).

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