Chapter 8—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.
ANS: A PTS: 1

2. Given a home country and a foreign country, purchasing power parity (PPP) suggests that:
d. a home currency will depreciate if the current home inflation rate exceeds the current
foreign inflation rate.
ANS: D PTS: 1

3. The international Fisher effect (IFE) suggests that:

a. a home currency will depreciate if the current home interest rate exceeds the current
foreign interest rate.
ANS: A PTS: 1

4. Because there are a variety of factors in addition to inflation that affect exchange rates, this will:
a. reduce the probability that PPP shall hold.
ANS: A PTS: 1

5. Because there are sometimes no substitutes for traded goods, this will:
a. reduce the probability that PPP shall hold.
ANS: A PTS: 1
 6. According to the IFE, if British interest rates exceed U.S. interest rates:
b. the British pound will depreciate against the dollar.
ANS: B PTS: 1

7. Given a home country and a foreign country, the international Fisher effect (IFE) suggests that:
d. none of the above
ANS: D PTS: 1

8. Given a home country and a foreign country, purchasing power parity suggests that:
d. none of the above
ANS: D PTS: 1

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.
ANS: A PTS: 1

10. If the international Fisher effect (IFE) did not hold based on historical data, then this suggests that:
c. some corporations with excess cash could have generated higher profits on average from
foreign short-term investments than from domestic short-term investments.
ANS: C PTS: 1

11. Under purchasing power parity, the future spot exchange rate is a function of the initial spot rate in
equilibrium and:
c. the inflation differential.
ANS: C PTS: 1
12. According to the international Fisher effect, if U.S. investors expect a 5% rate of domestic inflation
over one year, and a 2% rate of inflation in European countries that use the euro, and require a 3% real
return on investments over one year, the nominal interest rate on one-year U.S. Treasury securities
would be:
e. 8%.
ANS: E
SOLUTION: 5% + 3% = 8%

PTS: 1

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:
b. is due to their inflation differentials.
ANS: B PTS: 1

14. Assume that U.S. and British investors require a real return of 2%. If the nominal U.S. interest rate is
15%, and the nominal British rate is 13%, 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 .
e. 2 percentage points below; appreciate by about 2%
ANS: E PTS: 1

15. Assume U.S. and Swiss investors require a real rate of return of 3%. Assume the nominal U.S. interest
rate is 6% and the nominal Swiss rate is 4%. According to the international Fisher effect, the franc will
by about .
e. appreciate; 2%
ANS: E PTS: 1

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

ANS: A PTS: 1

17. According to the international Fisher effect, if Venezuela has a much higher nominal rate than other
countries, its inflation rate will likely be than other countries, and its currency will .
c. higher; weaken
ANS: C PTS: 1

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.
c. equal to
ANS: C PTS: 1

19. The Fisher effect is used to determine the:

b. real interest rate.
ANS: B PTS: 1

20. Latin American countries have historically experienced relatively high inflation, and their currencies
have weakened. This information is somewhat consistent with the concept of:
c. purchasing power parity.
 ANS: C PTS: 1

21. Assume that the inflation rate in Singapore is 3%, while the inflation rate in the U.S. is 8%. According
to PPP, the Singapore dollar should by %.
a. appreciate; 4.85

ANS: A
SOLUTION: (1.08/1.03)  1 = 4.85%.

PTS: 1

22. The inflation rate in the U.S. is 3%, while the inflation rate in Japan is 10%. The current exchange rate
for the Japanese yen (¥) is $0.0075. After supply and demand for the Japanese yen has adjusted in the
manner suggested by purchasing power parity, the new exchange rate for the yen will be:
 c. $0.0070.

ANS: C
SOLUTION: (1.03/1.10)  $.0075 = $.0070

PTS: 1

23. Assume that the U.S. inflation rate 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 U.S. According to purchasing power parity (PPP), this will result in a(n) of the
New Zealand dollar (NZ$).
b. increase; reduce; appreciation
ANS: B PTS: 1

24. 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:

c. purchasing power parity underestimated the exchange rate change during the period under
examination.
ANS: C PTS: 1

25. Which of the following is indicated by research regarding purchasing power parity (PPP)?
b. Deviations from PPP are reduced in the long run.

ANS: B PTS: 1

26. The interest rate in the U.K. is 7%, while the interest rate in the U.S. is 5%. The spot rate for the
British pound is $1.50. According to the international Fisher effect (IFE), the British pound should
adjust to a new level of:
a. $1.47.
 ANS: A
SOLUTION: (1.05/1.07)  (1.50) = $1.47.

PTS: 1

27. If nominal British interest rates are 3% and nominal U.S. interest rates are 6%, then the British pound
(£) is expected to by about %, according to the international Fisher effect (IFE).
b. appreciate; 2.9
ANS: B
SOLUTION: (1.06/1.03)  1 = 2.9%.

38. Which of the following theories suggests that the percentage change in spot exchange rate of a
currency should be equal to the inflation differential between two countries?
a. purchasing power parity (PPP).
ANS: A PTS: 1

39. 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?
d. interest rate parity (IRP).
ANS: D PTS: 1

40. Which of the following theories can be assessed using data that exists at one specific point in time?
d. interest rate parity (IRP).
ANS: D PTS: 1

41. 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?
c. international Fisher effect (IFE).
ANS: C PTS: 1

42. 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.
ANS: A PTS: 1

43. 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 = 0.4. Therefore:

purchasing power parity overestimated the exchange rate change during the period under
b. examination.
ANS: B PTS: 1

44. Assume that the one-year interest rate in the U.S. is 7% and in the U.K. is 5%. According to the
international Fisher effect, British pound's spot exchange rate should by about over the
year.
b. appreciate; 1.9%
ANS: B
SOLUTION: (1 + .07)/(1 + .05)  1 = 1.9%

PTS: 1

45. According to the international Fisher effect (IFE):

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.

ANS: B PTS: 1

46. Assume that the U.S. one-year interest rate is 5% and the one-year interest rate on euros is 8%. 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?
b. 5%
ANS: B PTS: 1

47. Assume that the U.S. one-year interest rate is 3% and the one-year interest rate on Australian dollars is
6%. The U.S. expected annual inflation is 5%, while the Australian inflation is expected to be 7%. 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?
c. 4%
ANS: C
SOLUTION: (1 + .05)/(1 + .07)  $0.689 = $0.676. ($100,000/A$0.689)  (1 + .06) =
A$153,846  $0.676 = $104,000. ($104,000  $100,000)/$100,000 = 4%

PTS: 1
48. Assume that the international Fisher effect (IFE) holds between the U.S. and the U.K. The U.S.
inflation is expected to be 5%, while British inflation is expected to be 3%. The interest rates offered
on pounds are 7% and U.S. interest rates are 7%. What does this say about real interest rates expected
by British investors?
c. real interest rates expected by British investors are 2 percentage points above the real
interest rates expected by U.S. investors.
ANS: C PTS: 1
53. Assume that the interest rate offered on pounds is 5% and the pound is expected to depreciate by 1.5%.
For the international Fisher effect (IFE) to hold between the U.K. and the U.S., the U.S. interest rate
should be .
a. 3.43%
ANS: A
SOLUTION: (1 + .05)  (1 + .015)  1 = 3.43%
58. The inflation rate in the U.S. is 4%, while the inflation rate in Japan is 1.5%. The current exchange rate
for the Japanese yen (¥) is $0.0080. After supply and demand for the Japanese yen has adjusted
according to purchasing power parity, the new exchange rate for the yen will be
b. $0.0082.
ANS: B PTS: 1

59. 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 U.S. According to purchasing power parity (PPP), this will result in a(n) of the New
Zealand dollar (NZ$).
c. reduce; increase; depreciation

ANS: C PTS: 1

60. The following regression was conducted for the exchange rate of the Cyprus pound (CYP):

Regression results indicate that a0 = 0 and a1 = 2. Therefore,

c. purchasing power parity underestimated the exchange rate change during the period under
examination.
ANS: C PTS: 1

61. Among the reasons that purchasing power parity (PPP) does not consistently occur are:
d. all of the above are reasons that PPP does not consistently occur.
ANS: D PTS: 1

62. 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.

ANS: A PTS: 1