International Money and Finance 8th

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Chapter 7 – Faculty Version

Multiple Choice

1. If absolute PPP holds, then the real exchange rate must be equal to:
a. a constant
b. a positive number
c. one
d. All of the above
Answer: D

2. We can expect deviations from absolute PPP because of:

a. different bundles of goods across countries
b. quotas and tariffs
c. transactions costs.
d. All of the above are correct
Answer: D

3. Suppose that the U.S. dollar price of a Big Mac is $3.57. The price of a Big Mac in China is 12.5
yuan. Suppose that the current exchange rate is 6.83 yuan per dollar. If absolute PPP holds, the
PPP-implied exchange rate is _______ and yuan is ________.
a. 3.50 yuan per dollar; overvalued.
b. 3.50 yuan per dollar; undervalued.
c. 1.83 yuan per dollar; overvalued.
d. 1.83 yuan per dollar; undervalued.
Answer: B

4. Suppose that the U.S. dollar price of a Big Mac is $3.57. The price of a Big Mac in Norway is 25
kroner. Suppose that the current exchange rate is 5.00 krone per dollar. If absolute PPP holds,
the PPP-implied exchange rate is _______ and krone is ________.
a. 5.00 krone per dollar; overvalued.
b. 5.00 krone per dollar; undervalued.
c. 7.00 krone per dollar; overvalued.
d. 7.00 krone per dollar; undervalued.
Answer: C

5. Relative PPP indicates that

a. The same goods are sold for the same price internationally.
b. The exchange rate between two countries is equal to the ratio of their price indexes.
c. The percentage change in the exchange rate is equal to the inflation differential
between two countries.
d. The inflation differential between two countries is equal to the forward premium.
Answer: C
6. Under Purchasing Power Parity,
a. S$/£ = PUS/PUK
b. S$/£ = PUK/PUS
c. S$/£ = PUS + PUK
d. S$/£ = PUS – PUK
Answer: A

7. A year ago the spot rate of U.S. dollars for Canadian dollars was $1/C$1. Since that time, the
rate of inflation in the U.S. has been 4% greater than that in Canada. Based on the theory of
Relative PPP, the current spot exchange rate of U.S. dollars for Canadian dollars should be
approximately _________ per Canadian dollars.
a. $0.96
b. $1
c. $1.04
d. $4
Answer: C

8. Which of the following statements is the most accurate?

a. Absolute PPP does not imply relative PPP.
b. Relative PPP implies absolute PPP.
c. Absolute PPP implies relative PPP.
d. There is no relationship between absolute and relative PPP.
Answer: C

9. Assume that the United States faces a 5 percent inflation rate while no (zero) inflation exists in
Japan. According to the relative PPP, the dollar would be expected to:
a. appreciate by 5 percent against the yen
b. depreciate by 5 percent against the yen
c. remain at its existing exchange rate
d. None of the above is correct.
Answer: B

10. Assume that the United States faces a 5 percent inflation rate while the U.K has a 7 percent
inflation rate. According to the relative PPP, the dollar would be expected to:
a. appreciate by 2 percent against the British pound
b. depreciate by 2 percent against the British pound
c. appreciate by 12 percent against the British pound
d. depreciate by 12 percent against the British pound
Answer: A
11. In the presence of purchasing-power parity, if one dollar exchanges for 2 British pounds and if a
flat-screen TV costs $400 in the United States, then in Great Britain the flat-screen TV should
cost:
a. 200 pounds
b. 400 pounds
c. 600 pounds
d. 800 pounds
Answer: D

12. Suppose the exchange rate between the U.S. dollar and the Japanese yen is initially 90 yen per
dollar. According to relative purchasing-power parity, if the price of traded goods rises by 10
percent in the United States and remains constant in Japan, the exchange rate will become:
a. 72 yen per dollar
b. 81 yen per dollar
c. 99 yen per dollar
d. 108 yen per dollar
Answer: B

13. Suppose the exchange rate between the U.S. dollar and the British pound is initially 2.00 dollars
per pound. According to relative purchasing-power parity, if the price of traded goods rises by
10 percent in the United States and remains constant in the U.K, the exchange rate will become:
a. 1.80 dollars per pound
b. 1.98 dollars per pound
c. 2.02 dollars per pound
d. 2.20 dollars per pound
Answer: D

14. Suppose Russia's inflation rate is 200% over one year but the inflation rate in Switzerland is only
2%. According to relative PPP,
a. the Russian ruble should depreciate against Swiss franc by 198 percent.
b. the Russian ruble should appreciate against Swiss franc by 198 percent.
c. the Russian ruble should depreciate against Swiss franc by 202 percent.
d. the Russian ruble should depreciate against Swiss franc by 202 percent.
Answer: A

15. If the nominal exchange rate in dollars per pound rises by 5%, the U.S. inflation is 2%, and the
U.K. inflation is 0%, what is the percent change in the real exchange rate?
a. 7%
b. 5%
c. 3%
d. 2%
Answer: C
16. Empirical evidence shows that in the short run, purchasing power parity _____, and in the long
run, purchasing power parity _____.
a. holds; does not hold
b. holds; holds
c. does not hold; holds
d. does not hold; does not hold
Answer: C

17. If the price of a pair of shoes in the U.S. is $80, the price of the same pair of shoes in Germany is
120 euro, and the exchange rate is 1.5 euro/$, the euro:
a. is correctly valued according to PPP.
b. is overvalued relative to PPP.
c. is undervalued relative to PPP.
d. None of the above is correct.
Answer: A

18. The equivalence of the percentage change in the exchange rate to the inflation differential
between countries is referred to as the:
a. Absolute PPP
b. Relative PPP
c. Interest rate parity
d. None of the above

Answer: B

19. ________ tends to hold better.

a. Absolute PPP
b. Relative PPP
c. Covered Interest Rate Parity
d. Big Mac Index

Answer: C

20. Assume that the U.S. has a 2 percent inflation rate while Sweden has a 7 percent inflation rate.
According to relative PPP, the dollar would be expected to:
a. Appreciate by 3.5 percent against the Swedish krona.
b. Depreciate by 3.5 percent against the Swedish krona.
c. Appreciate by 5 percent against the Swedish krona.
d. Depreciate by 5 percent against the Swedish krona.

Answer: C
21. In the presence of purchasing-power parity, if five pesos exchange for one dollar and a new
smartphone sells for $100 in Dallas, then the identical smartphone in Mexico City should cost:
a. 20 Pesos
b. 80 Pesos
c. 250 Pesos
d. 500 Pesos

Answer: D

22. If a currency has appreciated ________ the price differential between two countries as implied
by PPP, then a currency is ________.
a. The same as, undervalued
b. The same as, overvalued
c. Less than, overvalued
d. Less than, undervalued

Answer: D

23. If a pair of sunglasses costs $80 in the U.S. and 80 pounds in the U.K. and the exchange rate is
1.70 pound per dollar, then the pound is
a. Correctly valued according to PPP.
b. Undervalued relative to PPP.
c. Overvalued relative to PPP.
d. None of the above.

Answer: B

24. If the absolute PPP suggest that the dollar to pound should be 1.88 and the actual exchange rate
in London is 2.50 ($/pound), then:
a. The British pound is overvalued.
b. The U.S. dollar is overvalued
c. The British pound is undervalued
d. Exchange rates and absolute PPP are unrelated.

Answer: A
True/False

1. Purchasing power parity (PPP) explains the relationship between interest rates and product
price changes.
Answer: False
2. If a currency has appreciated more than the price differential between two countries as implied
by PPP, then a currency is overvalued.
Answer: True
3. The exchange rate that is actually observed in the foreign exchange market is called the real
exchange rate.
Answer: False
4. Purchasing power parity is used for short term analysis because it tends to fail in the long run.
Answer: False
5. The real exchange rate is equal to one when absolute PPP holds.
Answer: True
 Questions Posted on Student Companion Site

Chapter 7 –

Multiple Choice (15 Questions)

1. The relationship between product price levels and exchange rates is explained by:
a. Currency boards.
b. Purchasing power parity.
c. Per capita income levels.
d. Interest rate parity.

Answer: B

2. The equivalence of the exchange rate to the ratio of price levels between two countries is
referred to as the:
a. Absolute PPP
b. Relative PPP
c. Interest rate parity
d. None of the above

Answer: A

3. Assume that the U.S. has an 8 percent inflation rate while Mexico has a 4 percent inflation rate.
According to relative PPP, the dollar would be expected to:
a. Appreciate by 2 percent against the Mexican peso.
b. Depreciate by 2 percent against the Mexican peso.
c. Appreciate by 4 percent against the Mexican peso.
d. Depreciate by 4 percent against the Mexican peso.

Answer: D

4. Which of the following are reasons by the absolute PPP would not hold?
I. Consumer preferences
II. Transaction costs
III. Local taxes
IV. Company discounts
a. II only
b. IV only
c. I, II, and IV
d. I, II, and III

Answer: D
5. In the presence of purchasing-power parity, if one dollar exchanges for one Euro and a new
laptop sells for $750 in New York, then the identical laptop in Paris should cost:
a. 400 Euros
b. 600 Euros
c. 750 Euros
d. 1000 Euros

Answer: C

6. According to the law of one price, identical goods will have the same price in different markets
when the prices are expressed in the same currency if:
a. Both currencies are fixed.
b. Both currencies are floating.
c. There are no transaction costs and trade barriers.
d. Trade barriers protect arbitrary price changes.

Answer: C

7. Absolute PPP can be seen as an extension of ________ by generalizing the price of a good to the
countrywide level.
a. Relative PPP
b. Law of one price
c. Exchange rate equilibrium
d. Equilibrium currency

Answer: B

8. If a currency has appreciated ________ the price differential between two countries as implied
by PPP, then a currency is ________.
a. The same as, undervalued
b. The same as, overvalued
c. More than, overvalued
d. Less than, overvalued

Answer: C

9. If prices in the U.K. are rising slower than prices in the U.S. then
a. The pound depreciates.
b. The exchange rate stays the same.
c. The dollar depreciates.
d. The dollar appreciates.

Answer: C
10. The Big Mac index is used as:
a. A way to set exchange rates in different currencies
b. A way to set interest rates in different regions
c. A record of different ingredients in hamburgers in different regions
d. A measure of different prices in different countries

Answer: D

11. If a watch costs $50 in the U.S. and 100 Swiss francs in Switzerland and the exchange rate is 2.25
Swiss franc per dollar, then the dollar is:
a. Correctly valued according to PPP.
b. Undervalued relative to PPP.
c. Overvalued relative to PPP.
d. Not enough information to find answer.

Answer: C

12. If a bicycle costs $200 in the U.S. and 50 Swedish kronor in Sweden and the exchange rate is
0.25 Swedish krona per dollar, then the Swedish krona is:
a. Correctly valued according to PPP.
b. Undervalued relative to PPP.
c. Overvalued relative to PPP.
d. Not enough information to find answer.

Answer: A

13. If the absolute PPP suggest that the yen to U.S. dollar is 84.50 and the actual exchange rate in
New York is 85.50 (Yen/$), then:
a. The Japanese yen is overvalued.
b. The U.S. dollar is overvalued
c. The U.S. dollar is undervalued
d. Exchange rates and absolute PPP are unrelated.

Answer: B

14. After adjusting for inflation differentials between two countries, the exchange rate is referred to
as:
a. Predicted exchange rate
b. Real exchange rate
c. Nominal exchange rate
d. Inflation exchange rate

Answer: B
 15. Which of the following prices indices can be used in determining purchasing-power parity?
a. Producer price index
b. Consumer price index
c. GDP Deflator
d. All of the above

Answer: D

True/False (5 Questions)

1. If the inflation rates of two countries are both equal to the percentage change in the exchange
rate, then absolute purchasing power parity holds.
Answer: False
2. High-inflation countries rarely see purchasing power parity hold over time because of relative
price changes.
Answer: False
3. The purchasing power parity captures the connection between the goods market and foreign
exchange market.
Answer: True
4. The law of one price states that identical goods will have the same price in different markets as
long as trade barriers are in place.
Answer: False
5. Government restrictions are used to keep the purchasing power parity from deviating over time.
Answer: False