HOMEWORK 8 (CHAPTER 16 PRICE LEVELS AND THE EXCHANGE RATE IN THE LONG RUN) ECO41 FALL 2015 UDAYAN ROY

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1 HOMEWORK 8 (CHAPTER 16 PRICE LEVELS AND THE EXCHANGE RATE IN THE LONG RUN) ECO41 FALL 2015 UDAYAN ROY Each correct answer is worth 1 point. The maximum score is 20 points. This homework is due in class on Wednesday, December 2. Please show your answers on the answer sheet (on the last page). 1. Which of the following statements is the most accurate expression of the law of one price (also known as absolute purchasing power parity)? a. In competitive markets free of transportation costs and official barriers to trade, identical goods sold in the same country must sell for the same price when their prices are expressed in the same currency. b. In competitive markets free of transportation costs and official barriers to trade, identical goods sold in different countries must sell for the same price. c. In competitive markets free of transportation costs and official barriers to trade, identical goods sold in different countries must sell for the same price when their prices are expressed in the same currency. d. Identical goods sold in different countries must sell for the same price when their prices are expressed in the same currency. e. None of the above 2. Let E $/ be the dollars-per-euro exchange value of the euro, and let P US and P E be the overall price levels in USA and Europe, respectively. Under absolute purchasing power parity, a. E $/ = P E /P ES b. E $/ = P US + P E c. E $/ = P US /P E d. E $/ = P US P E e. None of the above. 3. Absolute purchasing power parity is the assumption that a. The domestic price level (P) is equal to the foreign price level (P*) once foreign prices are multiplied by the value of the foreign currency in units of the domestic currency (E) in order to express all prices in the same currency. Therefore, the real exchange rate is constant, though not necessarily equal to 1. b. The real exchange rate is constant, though not necessarily equal to 1. c. The domestic price level (P) is equal to the foreign price level multiplied by the value of the foreign currency in units of the domestic currency, in order to express all prices in the same currency. Therefore, P = E P*. This also implies that the real exchange rate is q = 1. d. The domestic interest rate (R) is equal to the foreign interest rate (R*) plus the expected rate of appreciation of the foreign currency. 4. Relative Purchasing Power Parity is the assumption that a. The domestic price level (P) is equal to the foreign price level (P*) once foreign prices are multiplied by the value of the foreign currency in units of the domestic currency (E) in order to

2 express all prices in the same currency. Therefore, P = E P*. This also implies that the real exchange rate is q = 1. b. The real exchange rate is constant, though not necessarily equal to 1. c. The domestic price level (P) is equal to the foreign price level (P*) once foreign prices are multiplied by the value of the foreign currency in units of the domestic currency (E) in order to express all prices in the same currency. Therefore, the real exchange rate is constant, though not necessarily equal to 1. d. The domestic interest rate (R) is equal to the foreign interest rate (R*) plus the expected rate of appreciation of the foreign currency. 5. Suppose the annual inflation rates in the USA and in Japan are 2% and 1%, respectively. Then, under purchasing power parity (absolute or relative), the dollars-per-yen exchange value of the yen will a. remain roughly constant over time b. decrease at the annual rate of 1% c. increase at the annual rate of 1% d. decrease at the annual rate of 3% e. increase at the annual rate of 3% 6. Under purchasing power parity (absolute or relative), a. The expected rate of appreciation of the foreign currency is equal to the excess of the foreign inflation rate over the domestic inflation rate b. If the foreign inflation rate is 7% and the domestic inflation rate is 5%, the foreign currency s value is expected to appreciate by 2% c. If the foreign inflation rate is 7% and the domestic inflation rate is 5%, the foreign currency s value is expected to depreciate by 2% d. If the foreign interest rate is 7% and the domestic interest rate is 5%, the foreign currency s value is expected to depreciate by 2% 7. Under fixed exchange rates, the expected rate of appreciation of the foreign currency is zero. Therefore, assuming purchasing power parity (absolute or relative), it must be that a. the foreign inflation rate equals the domestic inflation rate b. the foreign inflation rate equals the domestic inflation rate plus the domestic interest rate c. the foreign inflation rate is less than the domestic inflation rate d. the foreign inflation rate is unrelated to the domestic inflation rate 8. In the long run, a country s nominal interest rate (R) is affected by a. Both the level and the rate of growth of the money supply that is generated by its central bank b. The level but not the rate of growth of the money supply c. The rate of growth but not the level of the money supply d. Neither the level nor the rate of growth of the money supply 9. In the long run, a country s nominal interest rate (R) depends 2

3 a. Directly on the growth rate of its money supply b. Inversely on the growth rate of its potential GNP c. Directly on the foreign nominal interest rate (R*) d. Inversely on the foreign inflation rate (π*) e. All of the above 10. Suppose the annual inflation rates in the USA and in Japan are 2% and 1%, respectively. Also, suppose the interest rate paid by Japanese banks is 3% per year. Then, under purchasing power parity (absolute or relative) and interest parity (Ch. 14), the interest rate paid by American banks will be a. 0% b. 2% c. 3% d. 5% e. 6% 11. In the long run, a country s output (that is, real GNP, Y) a. Fluctuates around its full-employment output (Y f ) b. Is usually higher than its full-employment output c. Is usually lower than its full-employment output d. Is usually equal to its full-employment output e. Is largely unrelated to its full-employment output 12. In the long run, a country s inflation rate (π) a. Is equal to the rate at which the country s money supply is being increased by its central bank b. Is equal to the rate of increase of the money supply minus the rate of increase of the country s full-employment output c. Is equal to the rate of increase of the money supply plus the rate of increase of the country s full-employment output d. Is unrelated to the rate of increase of the money supply and the rate of increase of the country s full-employment output e. Is equal to the domestic interest rate minus the foreign interest rate 13. Assuming other exogenous variables are unaffected, if a country s central bank increases the rate at which it increases the country s money supply from 4% per year to 6% per year, which of the following long-run changes will occur? (Assume the country has a system of freely floating exchange rates.) a. The rate of inflation will rise by 2 percentage points b. The exchange value of the country s currency will fall by 2 percentage points c. The rate of interest paid by the country s banks will rise by 2 percentage points d. Real GNP (Y) and the real exchange rate (q) will be unaffected e. All of the above 3

4 14. In the long run, a country s price level (P) will rise if a. The money supply increases b. The growth rate of the money supply increases c. Full-employment output decreases d. The growth rate of full-employment output decreases e. All of the above 15. According to the theory of an open economy with freely floating exchange rates that was discussed in class, if the rate of inflation increases in a foreign country, how will the domestic economy be affected in the long run? a. its own inflation rate will increase b. its price level will increase c. the exchange value of its currency will decrease d. its real GNP and real exchange rate will both increase e. none of the above will happen 16. The idea that in the long run a country s inflation rate and interest rate tend to move together (in the same direction and to the same extent) is called a. The quantity theory of money b. Absolute purchasing power parity c. Uncovered interest parity d. Fisher effect 17. According to theory discussed in class, in the long run, higher prices in the foreign country will be accompanied by a. Higher value of the foreign country s currency b. Lower value of the foreign country s currency c. Higher prices in the domestic country d. Higher output in the domestic country e. Both (a) and (c) are correct 18. According to the section Empirical Evidence on PPP and the Law of One Price in your textbook, which of the following is most accurate? a. Both absolute and relative PPP do very well in explaining the facts b. Both absolute and relative PPP do badly in explaining the facts c. Absolute PPP does very well in explaining the facts but relative PPP does badly d. Relative PPP does very well in explaining the facts but absolute PPP does badly 19. Which of the following is the most accurate statement about the section Some Meaty Evidence on the Law of One Price in your textbook? 4

5 a. The Economist magazine collected data on Big Mac prices in various countries local currencies, and converted the local-currency prices into dollar prices by multiplying the local-currency prices by the dollar exchange rates of the local currencies. b. According to the Law of One Price, the price of a Big Mac, when converted into dollars, will be the same in all countries. Therefore, a comparison of the dollar prices of Big Macs all across the world would be a way to test the Law of One Price. c. According to The Economist s investigation, the Law of One Price does not fit the data on Big Mac prices very well d. All of the above answers are correct 20. According to the section Empirical Evidence on PPP and the Law of One Price in your textbook, which of the following is most accurate statement on the empirical testing of relative purchasing power parity? a. According to relative purchasing power parity theory, the real exchange rate (q = E P /P) would be constant in the long run, though not necessarily equal to 1. Suppose q = E P /P = 3. Then, E = 3P/P. In that case, E and P/P * should always move in the same direction and proportion. b. Checking to see if the euro price of a dollar (E /$ ) usually moves in the same direction and proportion as P Europe /P USA would be a good way to test RPPP. c. When this kind of comparison was done for various countries, it was found that RPPP has not done very well d. All of the above answers are correct 5

6 ANSWER SHEET HOMEWORK 8 (Ch. 16) ECO41 FALL 2015 UDAYAN ROY NAME: DATE: