Chapter 08: Relationships among Inflation, Interest Rates, and Exchange Rates
1. Assume a two-country world: Country A and Country B. Which of the following is correct about purchasing power
parity (PPP) as related to these two countries?
a.
If Country A’s inflation rate exceeds Country B’s inflation rate, Country A’s currency will weaken.
b.
If Country A’s interest rate exceeds Country B’s inflation rate, Country A’s currency will weaken.
c.
If Country A’s interest rate exceeds Country B’s inflation rate, Country A’s currency will strengthen.
d.
If Country B’s inflation rate exceeds Country A’s inflation rate, Country A’s currency will weaken.
2. Given a home country and a foreign country, purchasing power parity (PPP) suggests that:
a.
b.
c.
d.
3. The international Fisher effect (IFE) suggests that the foreign currency will appreciate when:
a.
the current home nominal interest rate exceeds the current foreign nominal interest rate.
b.
the current home real interest rate exceeds the current foreign real interest rate.
c.
the current home inflation rate exceeds the current foreign nominal interest rate.
d.
the current foreign inflation rate exceeds the current home inflation rate.
4. Because there are a variety of factors in addition to inflation that affect exchange rates, this will:
a.
reduce the probability that PPP will hold.
b.
increase the probability that PPP will hold.
c.
increase the probability the IFE will hold.
Chapter 08: Relationships among Inflation, Interest Rates, and Exchange Rates
d.
B and C
5. Because there are sometimes no substitutes for traded goods, this will:
a.
reduce the probability that PPP will hold.
b.
increase the probability that PPP will hold.
c.
increase the probability the IFE will hold.
d.
B and C
6. According to the IFE, if British interest rates exceed U.S. interest rates:
a.
the British pound’s value will remain constant.
b.
the British pound will depreciate against the dollar.
c.
the British inflation rate will decrease.
d.
the forward rate of the British pound will contain a premium.
e.
today’s forward rate of the British pound will equal today’s spot rate.
7. Given a home country and a foreign country, the international Fisher effect (IFE) suggests that:
a.
the nominal interest rates of both countries are the same.
b.
the inflation rates of both countries are the same.
c.
the exchange rates of both countries will move in a similar direction against other currencies.
d.
none of the above
8. Given a home country and a foreign country, purchasing power parity suggests that:
a.
the inflation rates of both countries will be the same.
b.
the nominal interest rates of both countries will be the same.
c.
A and B
d.
none of the above
5% + 3% = 8%
9. If interest rates on the euro are consistently below U.S. interest rates, then for the international Fisher effect (IFE) to
hold:
a.
the value of the euro would often appreciate against the dollar.
b.
the value of the euro would often depreciate against the dollar.
c.
the value of the euro would remain constant most of the time.
d.
the value of the euro would appreciate in some periods and depreciate in other periods, but on average have a
zero rate of appreciation.
10. If the international Fisher effect (IFE) did not hold based on historical data, this would suggest that:
a.
some corporations with excess cash could lock in a guaranteed higher return on future foreign short-term
investments.
b.
some corporations with excess cash could have generated profits on average from covered interest arbitrage.
c.
some corporations with excess cash could have generated higher profits on average from foreign short-term
investments than from domestic short-term investments.
d.
most corporations that consistently invest in foreign short-term investments would have generated the same
profits (on average) as from domestic short-term investments.
11. Under purchasing power parity, the future spot exchange rate is a function of the initial spot rate in equilibrium and:
a.
the income differential.
b.
the forward discount or premium.
c.
the inflation differential.
d.
none of the above
12. According to the international Fisher effect, if U.S. investors expect a 5 percent rate of domestic inflation over one
year and a 2 percent rate of inflation in European countries that use the euro, and if they require a 3 percent real return on
investments over one year, the nominal interest rate on one-year U.S. Treasury securities would be:
a.
2 percent.
b.
3 percent.
c.
−2 percent.
d.
5 percent.
e.
8 percent.
5% + 3% = 8%
13. According to the international Fisher effect, if investors in all countries require the same real rate of return, the
differential in nominal interest rates between any two countries:
a.
follows their exchange rate movement.
b.
is due to their inflation differentials.
c.
is zero.
d.
is constant over time.
e.
C and D
14. Assume that U.S. and British investors require a real return of 2 percent. If the nominal U.S. interest rate is 15 percent,
and the nominal British rate is 13 percent, then according to the IFE, the British inflation rate is expected to be about ____
the U.S. inflation rate, and the British pound is expected
to ____.
a.
2 percentage points above; depreciate by about 2 percent
b.
3 percentage points above; depreciate by about 3 percent
c.
3 percentage points below; appreciate by about 3 percent
d.
3 percentage points below; depreciate by about 3 percent
e.
2 percentage points below; appreciate by about 2 percent
15. Assume U.S. and Swiss investors require a real rate of return of 3 percent. Assume the nominal U.S. interest rate is 6
percent and the nominal Swiss rate is 4 percent. According to the international Fisher effect, the franc will ____ by about
____.
a.
appreciate; 3 percent
b.
appreciate; 1 percent
c.
depreciate; 3 percent
d.
depreciate; 2 percent
e.
appreciate; 2 percent
16. Assume that the U.S. and Chile nominal interest rates are equal. Then, the U.S. nominal interest rate decreases while
the Chilean nominal interest rate remains stable. According to the international Fisher effect, this implies expectations of
____ than before, and that the Chilean peso should ____ against the dollar.
a.
lower U.S. inflation; depreciate
b.
lower U.S. inflation; appreciate
c.
higher U.S. inflation; depreciate
d.
higher U.S. inflation; appreciate
Chapter 08: Relationships among Inflation, Interest Rates, and Exchange Rates
17. According to the international Fisher effect, if Venezuela has a much higher nominal interest rate than other countries,
its inflation rate will likely be ____ than other countries, and its currency will ____.
a.
lower; strengthen
b.
lower; weaken
c.
higher; weaken
d.
higher; strengthen
18. If interest rate parity holds, then the one-year forward rate of a currency will be ____ the predicted spot rate of the
currency in one year according to the international Fisher effect.
a.
greater than
b.
less than
c.
equal to
d.
answer is dependent on whether the forward rate has a discount or premium
19. The Fisher effect is used to determine the:
a.
real inflation rate.
b.
real interest rate.
c.
real spot rate.
d.
real forward rate.
20. Latin American countries have historically experienced relatively high inflation, and their currencies have weakened.
This information is somewhat consistent with the concept of:
a.
interest rate parity.
b.
locational arbitrage.
c.
purchasing power parity.
d.
the exchange rate mechanism.
21. The inflation rate in the United States is 3 percent while the inflation rate in Japan is 10 percent. The current exchange
rate for the Japanese yen (¥) is $0.0075. After supply and demand for the Japanese yen have adjusted in the manner
suggested by purchasing power parity, the new exchange rate for the yen will be:
a.
$0.0076.
b.
$0.0073.
c.
$0.0070.
d.
$0.0066.
(1.03/1.10) $.0075 = $.0070
22. Assume that the U.S. inflation rate is higher than the New Zealand inflation rate. This will cause U.S. consumers to
____ their imports from New Zealand and New Zealand consumers to ____ their imports from the United States.
According to purchasing power parity (PPP), this will result in a(n) ____ of the New Zealand dollar (NZ$).
a.
reduce; increase; appreciation
b.
increase; reduce; appreciation
c.
reduce; increase; depreciation
d.
reduce; increase; appreciation
23. The following regression analysis was conducted for the inflation rate information and exchange rate of the British
pound:
Regression results indicate that a0 = 0 and a1 = 2. Therefore:
a.
purchasing power parity holds.
b.
purchasing power parity overestimated the exchange rate change during the period under examination.
c.
purchasing power parity underestimated the exchange rate change during the period under examination.
d.
purchasing power parity will overestimate the exchange rate change of the British pound in the future.
24. Which of the following is indicated by research regarding purchasing power parity (PPP)?
a.
PPP clearly holds in the short run.
b.
Deviations from PPP are less pronounced in the long run.
c.
PPP clearly holds in the long run.
d.
There is no relationship between inflation differentials and exchange rate movements in the short run or long
run.
25. If nominal British interest rates are 3 percent and nominal U.S. interest rates are 6 percent, then the British pound (£)
is expected to ____ by about ____percent, according to the international Fisher effect (IFE).
a.
depreciate; 2.9
b.
appreciate; 2.9
c.
depreciate; 1.0
d.
appreciate; 1.0
e.
none of the above
Chapter 08: Relationships among Inflation, Interest Rates, and Exchange Rates
(1.06/1.03) − 1 = 2.9%.
26. There is much evidence to suggest that Japanese investors invest in U.S. Treasury securities when U.S. interest rates
are higher than Japanese interest rates. These investors most likely believe in the international Fisher effect.
a.
True
b.
False
27. Which of the following is not true regarding IRP, PPP, and the IFE?
a.
IRP suggests that a currency’s spot rate will change according to interest rate differentials.
b.
PPP suggests that a currency’s spot rate will change according to inflation differentials.
c.
The IFE suggests that a currency’s spot rate will change according to interest rate differentials.
d.
All of the above are true.
28. The relative form of purchasing power parity (PPP) accounts for the possibility of market imperfections such as
transportation costs, tariffs, and quotas in establishing a relationship between inflation rates and exchange rate changes.
a.
True
b.
False
29. According to the international Fisher effect (IFE), the exchange rate percentage change should be approximately equal
to the differential in income levels between two countries.
a.
True
b.
False
30. Research indicates that deviations from purchasing power parity (PPP) are less pronounced over the long run.
a.
True
b.
False
31. The IFE theory suggests that foreign currencies with relatively high interest rates will appreciate because the high
nominal interest rates reflect expected inflation.
a.
True
b.
False
32. If the IFE theory holds, that means that covered interest arbitrage is not feasible.
a.
True
b.
False
33. If interest rate parity holds, and the international Fisher effect (IFE) holds, foreign currencies with relatively high
interest rates should have forward discounts, and those currencies would be expected to depreciate.
a.
True
b.
False
34. Interest rate parity can only hold if purchasing power parity holds.
a.
True
b.
False
35. If interest rate parity holds, then the international Fisher effect must hold.
a.
True
b.
False
36. Which of the following theories suggests that the percentage change in the spot exchange rate of a currency should be
equal to the inflation differential between two countries?
a.
purchasing power parity (PPP)
b.
triangular arbitrage
c.
international Fisher effect (IFE)
d.
interest rate parity (IRP)
37. Which of the following theories suggests that the percentage difference between the forward rate and the spot rate
depends on the interest rate differential between two countries?
a.
purchasing power parity (PPP)
b.
triangular arbitrage
c.
international Fisher effect (IFE)
d.
interest rate parity (IRP)
38. Which of the following theories can be assessed using data that exists at one specific point in time?
a.
purchasing power parity (PPP)
b.
international Fisher effect (IFE)
c.
A and B
d.
interest rate parity (IRP)
39. Which of the following theories suggests the percentage change in spot exchange rate of a currency should be equal to
the interest rate differential between two countries?
a.
absolute form of PPP
b.
relative form of PPP
c.
international Fisher effect (IFE)
d.
interest rate parity (IRP)
40. The following regression analysis was conducted for the inflation rate information and exchange rate of the British
pound:
Regression results indicate that a0 = 0 and a1 = 1. Therefore:
a.
purchasing power parity holds.
b.
purchasing power parity overestimated the exchange rate change during the period under examination.
c.
purchasing power parity underestimated the exchange rate change during the period under examination.
d.
purchasing power parity will overestimate the exchange rate change of the British pound in the future.
41. Assume that the one-year interest rate in the United States is 7 percent and in the United Kingdom is 5 percent.
According to the international Fisher effect, the British pound’s spot exchange rate should ____ by about ____ over the
year.
a.
depreciate; 1.9 percent
b.
appreciate; 1.9 percent
c.
depreciate; 3.94 percent
d.
appreciate; 3.94 percent
42. According to the international Fisher effect (IFE):
a.
the nominal rate of return on a foreign investment should be equal to the nominal rate of return on the
domestic investment.
b.
the exchange rate–adjusted rate of return on a foreign investment should be equal to the interest rate on a local
money market investment.
c.
the percentage change in the foreign spot exchange rate will be positive if the foreign interest rate is higher
than the local interest rate.
d.
the percentage change in the foreign spot exchange rate will be negative if the foreign interest rate is lower
Chapter 08: Relationships among Inflation, Interest Rates, and Exchange Rates
than the local interest rate.
43. Assume that the U.S. one-year interest rate is 5 percent and the one-year interest rate on euros is 8 percent. You have
$100,000 to invest and you believe that the international Fisher effect (IFE) holds. The euro’s spot exchange rate is $1.40.
What will be the yield on your investment if you invest in euros?
a.
8 percent
b.
5 percent
c.
3 percent
d.
2.78 percent
44. Assume that the U.S. one-year interest rate is 3 percent and the one-year interest rate on Australian dollars is 6
percent. The U.S. expected annual inflation is 5 percent, while the Australian inflation is expected to be 7 percent. You
have $100,000 to invest for one year and you believe that PPP holds. The spot exchange rate of an Australian dollar is
$0.689. What will be the yield on your investment if you invest in the Australian market?
a.
6 percent
b.
3 percent
c.
4 percent
d.
2 percent
$0.676 = $104,000. ($104,000 − $100,000)/$100,000 = 4%
45. Assume that the international Fisher effect (IFE) holds between the United States and the United Kingdom. The U.S.
inflation is expected to be 5 percent, while British inflation is expected to be 3 percent. The interest rate offered on pounds
is 7 percent, and the U.S. interest rate is 7 percent. What does this say about real interest rates expected by British
investors?
Chapter 08: Relationships among Inflation, Interest Rates, and Exchange Rates
a.
Real interest rates expected by British investors are equal to the interest rates expected by U.S. investors.
b.
Real interest rates expected by British investors are 2 percentage points lower than the real interest rates
expected by U.S. investors.
c.
Real interest rates expected by British investors are 2 percentage points above the real interest rates expected
by U.S. investors.
d.
IFE doesn’t hold in this case because the U.S. inflation is higher than the British inflation, but the interest rates
offered in both countries are equal.
46. The international Fisher effect (IFE) suggests that the currencies with relatively high interest rates will appreciate
because those high rates will attract investment and increase the demand for that currency.
a.
True
b.
False
47. If purchasing power parity holds, then the Fisher effect must also hold.
a.
True
b.
False
48. If the international Fisher effect (IFE) holds, the local investors are expected to earn the same return from investing
internationally as they would from investing in their local markets.
a.
True
b.
False
49. Assume that inflation in the United States is expected to be 9 percent, while inflation in Australia is expected to be 5
percent over the next year. Today you receive an offer to purchase a one-year put option for $.03 per unit on Australian
dollars at a strike price of $0.72. Today the Australian dollar is quoted at $0.70. You believe that purchasing power parity
holds. You should accept the offer.
a.
True
b.
False
Spot rate in a year = (1.09/1.05) $0.70 = $0.73
50. Assume that the interest rate offered on pounds is 5 percent and the pound is expected to depreciate by 1.5 percemt.
For the international Fisher effect (IFE) to hold between the United Kingdom and the United States, the U.S. interest rate
should be ____.
a.
3.43 percent
b.
5.68 percent
c.
6.5 percent
d.
7.3 percent
51. Purchasing power parity (PPP) focuses on the relationship between nominal interest rates and exchange rates between
two countries.
a.
True
b.
False
52. The nominal interest rate can be measured as the real interest rate minus the expected inflation rate.
a.
True
b.
False
53. According to purchasing power parity (PPP), if a foreign country’s inflation rate is below the inflation rate at home,
home country consumers will increase their imports from the foreign country, and foreign consumers will lower their
demand for home country products. These market forces cause the foreign currency to appreciate.
a.
True
b.
False
54. According to the IFE, when the nominal interest rate at home exceeds the nominal interest rate in the foreign country,
the home currency should depreciate.
a.
True
b.
False
55. The inflation rate in the United States is 4 percent, while the inflation rate in Japan is 1.5 percent. The current
exchange rate for the Japanese yen (¥) is $0.0080. After supply and demand for the Japanese yen have adjusted according
to purchasing power parity, the new exchange rate for the yen will be
a.
$0.0078.
b.
$0.0082.
c.
$0.0111.
Chapter 08: Relationships among Inflation, Interest Rates, and Exchange Rates
d.
$0.00492.
e.
none of the above
56. Assume that the New Zealand inflation rate is higher than the U.S. inflation rate. This will cause U.S. consumers to
____ their imports from New Zealand and New Zealand consumers to ____ their imports from the United States.
According to purchasing power parity (PPP), this will result in a(n) ____ of the New Zealand dollar (NZ$).
a.
reduce; increase; appreciation
b.
increase; reduce; depreciation
c.
reduce; increase; depreciation
d.
reduce; increase; appreciation
57. The following regression was conducted for the exchange rate of the British pound (BP):
Regression results indicate that a0 = 0 and a1 = 2. Therefore,
a.
purchasing power parity holds.
b.
purchasing power parity overestimated the exchange rate change during the period under examination.
c.
purchasing power parity underestimated the exchange rate change during the period under examination.
d.
purchasing power parity will overestimate the exchange rate change of the British pound in the future.
58. Among the reasons that purchasing power parity (PPP) does not consistently occur are:
a.
exchange rates are affected by interest rate differentials.
Chapter 08: Relationships among Inflation, Interest Rates, and Exchange Rates
b.
exchange rates are affected by national income differentials and government controls.
c.
supply and demand may not adjust if no substitutable goods are available.
d.
all of the above are reasons that PPP does not consistently occur.
59. Which of the following is not true regarding limitations of PPP and the IFE?
a.
A limitation of the IFE is that the determination of the expected inflation rate is subject to error.
b.
A limitation in testing PPP is that the results will vary with the base period used.
c.
A limitation of the PPP and the IFE (because it relies on the PPP) is that other country characteristics besides
inflation can affect exchange rate movements.
d.
All of the above are true.