International Business Chapter 16 The Rise The Interest Rate From Creates Momentary Excess Supply Real Money

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The rise in the interest rate from to creates a momentary excess supply of real U.S.

money balances at the prevailing price level . However, since under this.

Monetary Approach, prices are assumed to be flexible, prices will immediately adjust from

to , thus causing the following two effects: One, Reducing real money supply and two,

bringing U.S. money market back into equilibrium.

Page Ref: 417-423

Difficulty: Moderate

24) To answer the following question, please refer to the figure below. Concentrating only at the

lower left quadrant, discuss the relationship between the U.S. real money supply and the

dollar/euro exchange rate, E$/E.

25) To answer the following question, please refer to the figure below. Concentrating only at the

upper right quadrant, discuss the foreign exchange market equilibrium.

26) Is a depreciation of the dollar/euro exchange rate correlated with a decrease in the dollar

return on U.S. deposits?

27) Does the existence of non-tradable goods allow for deviations from Purchasing power

Parity?

28) What effect do non-tradable goods have on PPP?

29) How can long run values in the real exchange rate change?

30) Describe the chain of events leading to exchange rate determination for the following cases:

(a) An increase in U.S. money supply

(d) Increase in growth rate of U.S. money supply

(d) Increase in relative U.S. output supply

31) Construct a table that will summarize the effects of money market and output market

changes on the long-run nominal dollar/euro exchange rate

Answer:

16.4 Empirical Evidence on PPP and the Law of One Price

1) In practice

A) changes in national price levels often tell us relatively little about exchange rate movements.

B) changes in national price levels raise the exchange rate.

C) changes in national price levels lower the exchange rate.

D) changes in national price levels often tell us about exchange rate movements.

E) changes in national price levels match identical changes in the exchange rate.

2) Which of the following statements is the MOST accurate?

A) The prices of identical commodity baskets, when converted to a single currency, are the same

across countries.

B) The prices of identical commodity baskets, when converted to a single currency, differ

substantially across countries.

C) The prices of identical commodity baskets, when converted to a single currency, do not differ

substantially across countries.

D) The prices of identical commodity baskets, when converted to a single currency, are often the

same across countries.

E) The prices of identical commodity baskets, when converted to a single currency, are the same

across countries more than 50% of the time.

3) Which of the following statements is the MOST accurate?

A) The law of one price does fare well in all recent studies.

B) The law of one price does fare well in many recent studies.

C) The law of one price sometimes fares well in recent studies.

D) The law of one price does not fare well in recent studies.

E) The law of one price has not been studied recently.

4) Which of the following statements is the MOST accurate?

A) Relative PPP is not a reasonable approximation to the data.

B) Relative PPP is sometimes a reasonable approximation to the data but often performs poorly.

C) Relative PPP is sometimes a reasonable approximation to the data.

D) PPP is sometimes a reasonable approximation to the data.

E) PPP is sometimes a reasonable approximation to the data but usually performs poorly.

5) What can explain the failure of relative PPP to hold in reality?

16.5 Explaining the Problems with PPP

1) Which of the following are theories meant to explain “Why Price Levels are Lower in Poorer

Countries”?

A) only Bhagwati-Kravis-Lipsey

B) only Balassa-Samuelson

C) only Goldberg-Knetter

D) Bhagwati-Kravis-Lipsey and Balassa-Samuelson

E) Bhagwati-Kravis-Lipsey and Goldberg-Knetter

2) In January 2013, the world’s cheapest Big Macs were sold in

A) the Philippines.

B) Russia.

C) China.

D) Malysia.

E) the Czech Republic.

3) The PPP theory fails in reality for all of the following reasons EXCEPT

A) transport costs.

B) monopolistic or oligopolistic practices in goods markets.

C) the inflation data reported in different countries are based on different commodity baskets.

D) restrictions on trade.

E) inflation rates are unrelated to money supply growth.

4) Which one of the following statements is the MOST accurate?

A) The purchasing power of any given country’s currency will increase in countries where the

prices of non-tradable goods rise.

B) The purchasing power of any given country’s currency will fall in countries where the prices

of non-tradable goods fall.

C) The purchasing power of any given country’s currency will fall in countries where the prices

of non-tradable goods rise.

D) The purchasing power of any given country’s currency will remain constant in countries

where the prices of non-tradable goods rise.

E) The purchasing power of any given country’s currency will fall in countries where the prices

of non-tradable goods remain constant.

5) Which one of the following statements is the MOST accurate?

A) Relative price changes could not lead to PPP violations even if trade were free and costless.

B) Relative price changes could lead to PPP violations only if trade were free and costless.

C) Relative price changes could lead to PPP violations even if trade were free and costless.

D) Price changes could lead to PPP violations even if trade were free and costless.

E) Price changes could not lead to PPP violations even if trade were free and costless.

6) Which one of the following statements is the MOST accurate?

A) Departures from PPP are similar in both the short run and long run.

B) Departures from PPP are even greater in the long run than in the long run.

C) Departures from PPP are always greater in the short run than in the long run.

D) It is hard to tell whether departures from PPP are greater in the short run than in the long run.

E) Departures from PPP may often be greater in the short run than in the long run.

7) Floating exchange rates

A) systematically lead to much larger but less frequent short-run deviations from the absolute

PPP.

B) systematically lead to much larger and more frequent short-run deviations from the relative

PPP.

C) systematically lead to much smaller and less frequent short-run deviations from the relative

PPP.

D) systematically lead to much smaller but more frequent short-run deviations from the relative

PPP.

E) systematically lead to much smaller and less frequent short-run deviations from the absolute

PPP.

8) Explain why price levels are lower in poorer countries.

16.6 Beyond Purchasing Power Parity: A General Model of Long-Run Exchange Rates

1) Which of the following statements is the MOST accurate about the Law of One Price on

Scandinavian ferry lines?

A) Due to menu costs, the Law of One Price does not hold.

B) To avoid arbitrage opportunities, the Law of One Price must hold.

C) Transaction costs of exchanging currency causes the Law of One Price to fail.

D) Transportation costs between ferry lines leads to a violation of the Law of One Price.

E) The physical distance allowed the Law of One Price to hold.

2) Which of the following statements is MOST accurate?

A) The United States price level will place a relatively light weight on commodities produced

and consumed in America, while the European price level will place a relatively heavy weight on

commodities produced and consumed in Europe.

B) The United States price level will place a relatively light weight on commodities produced

and consumed in America, and the European price level will place a relatively light weight on

commodities produced and consumed in Europe.

C) The United States price level will place a relatively heavy weight on commodities produced

and consumed in America, and the European price level will place a relatively heavy weight on

commodities produced and consumed in Europe.

D) The United States price level will place a relatively heavy weight on commodities produced

and consumed in Europe, and the European price level will place a relatively heavy weight on

commodities produced and consumed in America.

E) The United States price level will place a relatively light weight on commodities produced

and consumed in Europe, and the European price level will place a relatively heavy weight on

commodities produced and consumed in America.

3) When the domestic money prices of goods are held constant

A) a nominal dollar appreciation makes U.S. goods cheaper compared with foreign goods.

B) a nominal dollar depreciation makes U.S. goods less appealing in foreign markets.

C) a nominal dollar appreciation does not affect the prices of U.S. goods.

D) a nominal dollar depreciation makes U.S. goods more expensive compared with foreign

goods.

E) a nominal dollar depreciation makes U.S. goods cheaper compared with foreign goods and a

nominal dollar appreciation makes U.S. goods more expensive compared with foreign goods.

4) An increase in the world relative demand for U.S. output causes

A) a short-run real depreciation of the dollar against the euro.

B) a long-run real appreciation of the dollar against the euro.

C) a long-run real depreciation of the dollar against the euro.

D) a short-run real appreciation of the euro against the dollar.

E) a long-run real appreciation of the euro against the dollar.

5) Which of the following statements is MOST accurate?

A) A relative expansion of U.S. output causes a long-run depreciation of the dollar against the

euro, while a relative expansion of European output causes a long-run real appreciation of the

dollar against the euro.

B) A relative decline of U.S. output causes a long-run depreciation of the dollar against the euro,

while a relative expansion of European output causes a long-run real appreciation of the dollar

against the euro.

C) A relative expansion of U.S. output causes a long-run appreciation of the dollar against the

euro, while a relative expansion of European output causes a long-run real depreciation of the

dollar against the euro.

D) A relative expansion of U.S. output causes a long-run depreciation of the dollar against the

euro, while a relative decline of European output causes a long-run real appreciation of the dollar

against the euro.

E) A relative decline of U.S. output causes a long-run depreciation of the dollar against the euro,

while a relative decline of European output causes a long-run real appreciation of the dollar

against the euro.

6) When all variables start out at their long-run equilibrium levels, the most important

determinant of long-run swings in nominal exchange rates is

A) a shift in relative money supply levels.

B) a shift in relative money supply growth rates.

C) a change in relative output demand.

D) a change in relative output supply.

E) a change in relative inflation rates.

7) Which of the following statements is MOST accurate?

A) In the output market, an increase in demand for U.S. output leads to an increase in the long-

run nominal dollar/euro exchange rate.

B) In the output market, an increase in the demand for European output leads to an increase in

the long-run nominal dollar/euro exchange rate.

C) In the output market, a decrease in demand for U.S. output leads to a decrease in the long-run

nominal dollar/euro exchange rate.

D) In the output market, an increase in the demand for European output leads to a decrease in the

long-run nominal dollar/euro exchange rate.

E) In the output market, an increase in the demand for European output leads to an increase in

the long-run nominal euro/dollar exchange rate.

8) Which of the following statements is MOST accurate?

A) In the money market, an increase in U.S. money supply level leads to a proportional increase

in the long-run nominal dollar/euro exchange rate.

B) In the money market, an increase in European money supply level leads to a proportional

increase in the long-run nominal dollar/euro exchange rate.

C) In the money market, an increase in U.S. money supply growth rate leads to a decrease in the

long-run nominal dollar/euro exchange rate.

D) In the money market, an increase in European money supply growth leads to an increase in

the long-run nominal dollar/euro exchange rate.

E) In the money market, an increase in U.S. money supply level leads to a proportional decrease

in the long-run nominal dollar/euro exchange rate.

9) In the long run

A) exchange rates obey relative PPP when all disturbances occur in the output markets.

B) exchange rates obey absolute PPP when all disturbances occur in the output markets.

C) exchange rates are unlikely to obey relative PPP when all disturbances occur in the output

markets.

D) exchange rates are unlikely to obey relative PPP when all disturbances are monetary in

nature.

E) exchange rates obey absolute PPP when all disturbances are monetary in nature.

10) Discuss the different effects on the domestic interest rates when prices are assumed flexible

and when they are assumed to be sticky.

11) What are the predictions of the PPP theory with regards to the real exchange rates?

12) What is the real exchange rate between the dollar and the euro equal to?

13) Discuss why the empirical support for PPP and the law of one price is weak in recent data.

14) Define the concept of the real exchange rate and explain how it differs from the nominal

exchange rate.

16.7 International Interest Rate Differences and the Real Exchange Rate

1) Interest rate differences between countries depend on

A) differences in expected inflation, but not on expected changes in the real exchange rate.

B) differences in expected changes in the real exchange rate, but not on expected inflation.

C) neither differences in expected inflation, nor on expected changes in the real exchange rate.

D) differences in expected inflation and nothing else.

E) differences in expected inflation, and on expected changes in the real exchange rate.

2) The expected rate of change in the nominal dollar/euro exchange rate is best described as

A) the expected rate of change in the real dollar/euro exchange rate minus the U.S.-Europe

expected inflation difference.

B) the expected rate of change in the real dollar/euro exchange rate plus the U.S.-Europe real

interest rate difference.

C) the expected rate of change in the real dollar/euro exchange rate plus the U.S.-Europe

expected inflation difference.

D) the expected rate of change in the real dollar/euro exchange rate minus the U.S.-Europe real

interest rate difference.

E) the expected rate of change in the real dollar/euro exchange rate plus the European expected

inflation.

16.8 Real Interest Parity

1) The expected real interest rate (re) in terms of the nominal interest rate (R) and the expected

inflation rate (πe) is given by

A) re = πe + R.

B) re = 2πe + R2.

C) re = πe + R2.

D) re = R – πe.

E) re = R2 – πe.

2) 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.

3) What is the real interest rate parity condition?

16.9 Appendix to Chapter 16: The Fisher Effect, the Interest Rate, and the Exchange Rate

Under the Flexible-Price Monetary Approach

1) The monetary approach to interest rates assumes that the prices of goods are ________, which

implies that a country’s currency will ________, when nominal interest rates ________ because

of ________ expected future inflation.

A) perfectly flexible; depreciate; increase; higher

B) perfectly flexible; appreciate; increase; higher

C) immutable; depreciate; increase; higher

D) immutable; appreciate; decrease; higher

E) absolutely inflexible; depreciate; decrease; higher

2) When the nominal dollar interest rate ________, money demand will ________, and the

general price level will ________.

A) increases; decrease; increase

B) increases; increase; increase

C) increases; decrease; decrease

D) increases; increase; decrease

E) decreases; increase; increase