Deck 8: Relationships among Inflation, Interest Rates, and Exchange Rates

Question 1

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

Answer 1

A

Question 2

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

Answer 2

A

Question 3

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.

Answer 3

A

Question 4

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

Question 5

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.

Question 6

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.
D)B and C

Question 7

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

Question 8

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

Question 9

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.

Question 10

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

Question 11

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

Question 12

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

Question 13

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

Question 14

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.

Question 15

The Fisher effect is used to determine the:

A)real inflation rate.
B)real interest rate.
C)real spot rate.
D)real forward rate.

Question 16

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.

Question 17

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.

Question 18

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.

Question 19

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

Question 20

Given a home country and a foreign country, purchasing power parity (PPP) suggests that:

A)the home currency will depreciate if the current home inflation rate exceeds the current foreign interest rate.
B)the home currency will appreciate if the current home interest rate exceeds the current foreign interest rate.
C)the home currency will appreciate if the current home inflation rate exceeds the current foreign inflation rate.
D)the home currency will depreciate if the current home inflation rate exceeds the current foreign inflation rate.

Question 21

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.

Question 22

The IFE theory suggests that foreign currencies with relatively high interest rates will appreciate because the high nominal interest rates reflect expected inflation.

Question 23

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.

Question 24

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.

Question 25

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.

Question 26

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

Question 27

Research indicates that deviations from purchasing power parity (PPP) are less pronounced over the long run.

Question 28

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.

Question 29

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

Question 30

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)

Question 31

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.

Question 32

Interest rate parity can only hold if purchasing power parity holds.

Question 33

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.

Question 34

If interest rate parity holds, then the international Fisher effect must hold.

Question 35

If the IFE theory holds, that means that covered interest arbitrage is not feasible.

Question 36

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)

Question 37

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.

Question 38

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)

Question 39

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)

Question 40

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.

Question 41

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 than the local interest rate.

Question 42

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.
D)$0.00492.
E)none of the above

Question 43

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

Question 44

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

Question 45

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

Question 46

The nominal interest rate can be measured as the real interest rate minus the expected inflation rate.

Question 47

If purchasing power parity holds, then the Fisher effect must also hold.

Question 48

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

Question 49

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?

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.

Question 50

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.

Question 51

Among the reasons that purchasing power parity (PPP) does not consistently occur are:

A)exchange rates are affected by interest rate differentials.
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.

Question 52

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.

Question 53

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.

Question 54

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.

Question 55

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

Question 56

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.

Question 57

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.

Question 58

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.

Question 59

Purchasing power parity (PPP) focuses on the relationship between nominal interest rates and exchange rates between two countries.